The choice of a suitable retirement plan can be a daunting task for many retirees under the contributory pension scheme. This task is not made any easier by the cacophony emanating from various pension marketers desperately pitching their respective pension plans to the hapless retiree. Annuity marketers from the insurance companies would make their sales pitch on long retirement years without any financial worries or fears of running out of retirement income.
The Pension Fund Administrators (PFAs) in a bid not to be outdone would argue that with good investment returns, there is no reason why a Programmed Withdrawal plan should not only provide pension for life but would also leave the bulk of the Retirement Savings intact for a named beneficiary to inherit. With each group marshalling out points and counter points on the superiority of their own retirement pension plan, it is no wonder that many retirees end up with information overload without any useful headway made in grasping the core issues at stake.
However, if sentiments were put aside, the simple truth that neither the PFA nor the insurers would admit is that neither plan is universally superior to the other. The reason for this is that the risk-reward tradeoff inherent in both pension plans places them at par. Therefore, the critical issue is not the superiority of either plan but its suitability based on the risk tolerance of the individual retiree. An analogy can be drawn between investment in fixed income securities such as treasury bills and investment in the shares of a company. Which of the two is a better investment depends on who you are talking to.
Both the programmed withdrawal and the annuity pension plans are subject to similar risks, namely investment risk and longevity risk. The major difference between the plans arises from who actually bears the risks and by extension enjoys therewards for risk taking. The investment risk is the risk of erosionof retirement funds resulting from significant investment losses.The longevity risk on the other hand is the risk that comes with the passage of time. It is the risk that if sufficient time passes the retirement funds could eventually get depleted in the face of continuous withdrawals.
Under programmed withdrawal, the retiree bears the risks and hence also enjoys whatever rewards there might be. The rewards could come directly in the form of periodic increment in the monthly pension payout, if investment returns are good. Also, a named beneficiary is entitled to the residue of the retirement funds at the death of the retiree. The risk of course is that these rewards are not automatic; they depend on how good investment returns turn out to be. If investment returns are poor, the retiree could actually run out of retirement income and face old age with no pensions at all. The Pension act provides for a minimum pension that is payable to the retiree under these circumstances.However, the modalities for this is still been worked out by the relevant authorities.
Under the annuity plan, the insurer performs its traditional role of risk bearing, protecting the retiree against both investment and longevity risks. Hence, the retiree is assured of his pension for as long as he lives. Furthermore, there is a 10 year guaranteed period within which the beneficiary’s interest is accommodated since they can inherit from the residue of the retirement savings.
But it is not all good news as the beneficiary will not have anything to inherit if the retiree dies after ten years into the annuity plan. This is because the entire original fund brought into the plan would have been disbursed as pension payments to the retiree. As if this is not enough bad news for the beneficiary, the lump sum paid is the calculated present value of the outstanding payment due to the retiree within the 10 year guaranteed period.
With a full understanding of the risk-reward relationship, a retiree should assess himself to determine the risk he can comfortably bear given his risk appetite and his financial position. Can he still enjoy a satisfying retirement if his pension stops? Is the financial need of his beneficiaries sufficiently great to justify running the risk of no pension so as to provide a nebulous inheritance for them? Is the potential periodic increment substantial enough to warrant the risk of no pension in old age?
The decision is never an easy one to make given the pros and cons of both pension plans – pension security that comes with an annuity against the potential for investment income that comes with a programmed withdrawal.
However, nothing should prevent a retiree from having the best of both worlds if only the pension act could be reviewed so that retirees with sufficient funds in their RSA could split their funds between an annuity pension plan and a programmed withdrawal. Hopefully, if this is ever done, it would go a long way in making the pension decision process a lot easier on the retirees. In the interim, a retiree can only choose a plan and hope for the best.
—Igboanu is an economist, associate of the Certified Pension Institute of Nigeria and graduate of the Chartered Institute of Stockbrokers.