Bernard Yen | Aon Hewitt: “Replacing the funded NPF with the unfunded CSG is not a good move”

Having worked for years on the matter, Bernard Yen, Managing Director of Aon Hewitt, has a thorough understanding of pension-related issues. He talks to Investor’s Mag about the recent changes brought to the pension system in Mauritius, which, in his view, is a definite time bomb.

Featured in Investor’s Mag, 21th Edition, June 22 – Aug 22

What are the main challenges for national pension systems worldwide?

If you think about it, the main objective of any pension system is to provide an income for life to people who have retired and are generally no longer able to work and earn a living. This system can take several forms. For example, at an individual level, it can be as simple as family support and the pensioner’s own savings kept in bank accounts or as sophisticated as the pensioner’s own investments in a variety of bonds, shares, and property. In general, individuals do not have enough wealth and knowledge to save enough in a diversified way, so they need help with collective or group schemes. These schemes can be privately run by insurance companies, investment managers and pension funds sponsored by employers or publicly run by government or parastatal bodies. They can be funded or unfunded. A funded scheme is one where contributions are collected from salaries and other income during employment, invested in a fund and then paid out during retirement. An unfunded scheme is one where there is no fund invested at any time: the contributions which are collected during employment are paid over straightway to pensioners in the hope that, when the workers retire later, the younger generation will then pay for their pensions in turn.

The main challenges for national pension systems worldwide are that they were generally set up many years ago in very different situations and may no longer be fit or resilient enough for today’s environment. For example, many countries provide a social security pension that is unfunded and is paid to all citizens above a certain age such as 60 or 65. In the past, there would not be many pensioners living beyond 70 or 75 and there would be a lot of workers aged 16 and above to contribute to their pensions. However, people are now living much longer and many workers only start working much later after tertiary education at age 21 or more. There are fewer and fewer workers contributing to more and more pensioners and that’s why many countries have had to increase their national retirement age from 60 to 65, 67 or even 70 as well as increase taxes to support their systems.

Even funded systems which in theory are more robust than unfunded ones, have been challenged by increasing pensioner longevity because many of them were set up as final salary defined benefit (DB) plans rather than defined contribution (DC) plans. Final salary DB plans pay pensions according to formulae based on each employee’s service and final salary before retirement, with no regard as to whether the fund has enough money or not. In contrast, DC plans pay pensions according to what each employee’s share in the fund amounts to. DB plans have generally accumulated deficits in past decades because pensioners are living longer than previously expected and because investments have been yielding lower and lower returns in a declining interest rate environment. 20 years ago, it seemed reasonable to assume that investing Rs1,000 would be sufficient to pay Rs2,000 after 7 years because we could earn 10% annual interest over the 7 years. Today, we can only expect to earn 5% per annum, and therefore we now need to invest Rs1,400 instead of Rs1,000 in order to pay Rs2,000 after 7 years.

Finally, each country is different, and therefore whichever systems have worked well in one country may not work well in another country. Each country has to find its own optimal combination of systems and have the right governance mechanisms in place to embark on the necessary reforms.

“For the CSG, there is still time for the government to make it targeted before it is due to be paid as from July 2023…”

Bernard Yen | Managing Director | Aon Hewitt

What about Mauritius, where pension costs are bound to continue to rise due to demographic pressures and political promises?

In Mauritius, we have an interesting combination of systems which I have been proud to present to other pension professionals at conferences around the world.

The first pillar is the basic retirement pension (BRP) which is a flat amount paid to nearly everyone over the age of 60 for life. It is unfunded and paid out of general taxation.

The second pillar comprises the National Pension Fund (NPF), which pays an earnings-related amount up to a ceiling. It is funded and paid out of prior contributions. Unfortunately, in my view, the NPF is now being phased out in favour of the Contribution Sociale Généralisée (CSG) which is another flat amount to be paid to everyone over the age of 65 for life. It is unfunded and to be paid out of an additional income tax on employees, employers and the self-employed.

The second pillar also comprises the Sugar Industry Pension Fund (SIPF), the Statutory Bodies Pension Fund (SBPF), the Civil Service Pension Scheme (CSPS), and parliamentary pensions, which provide earnings-related pensions. SIPF and SBPF are funded, whereas CSPS and parliamentary pensions are largely unfunded and paid out of general taxation.

The third pillar comprises the National Savings Fund (NSF) and the Portable Retirement Gratuity Fund (PRGF), which pay earnings-related lump sums on retirement. They are funded and paid out of prior contributions.

The fourth pillar comprises private occupational pension plans set up voluntarily by employers, individuals’ personal pension plans, and all other forms of private savings and investments. They are funded and paid out of prior contributions.

The fifth pillar comprises all other forms of help given to the elderly, e.g. family support, free transport, and healthcare assistance.

As I mentioned before, demographic pressures affect all pension systems, but unfunded systems are the most at risk. Therefore, we need to watch especially the BRP, the CSG and the CSPS. If nothing is done to change these systems, they will need to be maintained by higher and higher levels of taxation on lower and lower proportions of workers in particular.

This is why replacing the funded NPF with the unfunded CSG is not a good move. Most countries are trying to move from unfunded to funded systems to become more robust over time, but they can find it difficult because this effectively requires one working generation to pay twice: firstly for the pensioners because it’s their turn to be paid by the younger generation and secondly for themselves because the next generation will not pay for them under a funded system.

Conversely, moving from funded to unfunded is a windfall for one generation of pensioners: they receive pensions from their past contributions to the funded system (e.g. NPF) as well as pensions from the new unfunded system (e.g. CSG) to which they never had to contribute. The next generation will not be so fortunate: only a small NPF pension from any contributions made before September 2020 and a flat CSG pension to which they will need to contribute almost all their lives! Add to that the fact that the NPF was designed to reduce the gap between private and public sector pensions. In contrast, the CSG pension will be paid to public sector retirees on top of already generous public pensions. You will understand why Business Mauritius in the past and now a company called Youth Contribution to Society Ltd (YCSL) is now challenging the constitutionality of the CSG legislation in the courts.

Finally, political promises to increase the amounts paid under the BRP/CSG at a faster rate than our economy can sustain will only compound our problems further. I believe the BRP at Rs9,000 for all over 60 is not sustainable, the CSG at Rs4,500 for all over 65 is also not sustainable and I am disappointed that some are now saying they need to provide Rs15,000 without saying where they will find the money to pay for all of this!

Is Mauritius pension system a time bomb?

Definitely yes. It is unfortunate, however, that many do not seem to care because they will no longer be around when the bomb goes off.

Pension funds were developed decades ago under vastly different assumptions regarding life expectancy and working-age population growth etc…What can the authorities do to rectify the situation? Should they press on the reset button?

I think it is clear that our political system cannot deliver the required pension reforms unless some form of national consensus is achieved across all political parties. This is why I keep suggesting that any government needs to initiate and encourage wide consultation on our pension systems so that the necessary reforms can be made with cool heads without the risk of being overturned every 5 years by each successive government.

I am not sure what you mean by pressing the reset button, but I would like to think it might apply in the case of CSG! Maybe the courts will force the government to do so in due course, but much damage would have already been caused by then.

Otherwise, there are many ways in which the situation can be rectified and we only need some goodwill from any government to address the problems and find the right solutions with expert help and wide consultation.

“Firstly, I think it should not be paid to public sector pensioners at all because they did not have to receive any NPF pension, and so they do not need to obtain any CSG…”

Bernard Yen | Managing Director | Aon Hewitt

A new threat has emerged in the form of rapidly rising inflation and the possibility of rate increases after several years of persistent lows. What do rising inflation and interest rates mean for pensions?

Surprisingly, high inflation and rising interest rates can be relatively good news for unfunded pension systems! This is because these systems are in fact a form of hidden debt. The BRP at Rs9,000, if you were to place a capital value on it, would actually be equivalent to a hidden national debt of more than Rs300bn or 60% of GDP! Now, if inflation continues to rise and averages, for example, 7% per annum, the Rs9,000 will effectively cost less and less to government in real terms, and the unhidden debt as a percentage of rapidly rising nominal GDP could become 50%, 40% and 30% of GDP quite quickly.

A similar observation can be made for the CSG if it remains flat at Rs4,500 for many years. Its effective cost as a percentage of GDP can go down with time if inflation remains high.

Of course, life is not so simple! This scenario also means that the pensioners will increasingly complain that the Rs9,000 and the Rs4,500 are rapidly losing their purchasing power and the government may be forced to increase them annually in line with inflation sooner rather than later. You are aware that we are already seeing calls for the BRP to increase since last year!

Are you for or against the idea of introducing targeting in terms of universal retirement pension?

I am for the idea of targeting social security toward the most needy in general, but I know it is difficult to make it acceptable without proper communication. For the BRP, I think it will be too difficult to reintroduce the idea of targeting, and in general, it is difficult for people to accept any cutback on what they are already receiving. That is why, for the BRP, it might be better to delay its payment until age 65 only for new pensioners in a phased manner, i.e. reduce it before they even start getting it! This should have been done as previously announced between 2008 and 2018, but we all know the government at the time decided not to implement it in the end.

For the CSG, there is still time for the government to make it targeted before it is due to be paid as from July 2023. Firstly, I think it should not be paid to public sector pensioners at all because they did not have to receive any NPF pension, and so they do not need to obtain any CSG pension now! Secondly, those who already receive good NPF and other pensions in the private sector should also not receive any CSG pension. If these principles can be accepted and explained, we can then work out the details where the situations are not so clear-cut, hence the need for wide consultation in any case before embarking on any pension reforms.

What are the most sustainable ways or new avenues to finance retirement plans?

As I mentioned, the most sustainable systems are the funded ones, which should also be monitored closely and well managed, particularly on the investment side.

Personally, after more than 35 years working on pensions, I have come to the conclusion that workplace pensions in the fourth pillar are perhaps the most effective in delivering adequate pensions at a reasonable cost. Focusing on State systems only in the first and second pillars has its place, but they can be so big as to belong to everybody in theory and nobody in practice at the same time. For example, the NPF has never been able to shake off its reputation of a large system covering more than 500,000 members and yet largely untrusted to deliver adequate pensions. At the other extreme, relying on personal savings or family in the fourth and fifth pillars is not generally a satisfactory and efficient solution unless a great deal of time is spent on financial education and the lessons put into practice by each person. In between, workplace pensions sponsored by employers and well managed by governing bodies such as trustees with the help of professionals can be the most effective in achieving reasonable economies of scale and keeping the members interested in taking ownership of their retirement plans and expectations.

Again, any national pension reform should focus on all the pillars and ensure they work together rather than against each other. For example, the introduction of PRGF and CSG should not discourage workplace pensions unless they are superior. PRGF is a great initiative that is useful for small employers or the self-employed who will never bother with setting up workplace pensions. However, it only delivers a lump sum at retirement, and I think most people would be better off with a small pension for life than a big lump sum which can be spent too quickly. We should ensure workplace pensions are encouraged at all times because it is a form of self-help which relieves the State to focus on the most needy in the first and second pillars.