Report on the increase in minimum interest rate (SI 157 of 2002)

prepared by Pentact (Private) Limited: Thursday, June 20, 2002
  1. INTRODUCTION
    1. There has been quite a significant development in the pension fund industry with the release of SI 157 of 2002. The purpose of this letter is to set out our initial reaction to the proposal and what action if any should be taken by pension funds.
    2. I must emphasise two points:
      1. The advice is given to pension funds "in general" and may not apply in specific cases.
      2. We are not lawyers and we are interpreting this legislation as actuaries and pension consultants. Should any important questions hinge on the exact wording we would recommend that legal advice is sought.
  2. THE CHANGE
    1. A copy of the Statutory Instrument is attached with this letter. You will notice that four sections (18, 19, 20 and 27) of the Pension & Provident Fund Regulations ("the Regulations") have been amended.
    2. Basically, all these amendments increase the minimum rate of interest payable to a member on exit from a fund from 4% per annum simple interest to:
    3. "the interest that would have been earned on the Fund".
    4. If we take the case of section 18, this refers to the situation where a person "ceases to be a member" and therefore potentially affects all exits from active service, namely withdrawal, retrenchment, death and all forms of retirement.
    5. The minimum benefit now is the sum of:
      1. the member's contributions plus the interest earned on the Fund; plus
      2. a percentage of the amount in (a) in accordance with a scale based on service (which starts at 25% after 5 years service and rises to 100% at 15 years).
    6. Section 19 increases the "deemed benefits" payable from non-contributory schemes.
    7. Section 20 similarly increases the minimum benefit which must be taken into account when calculating whether gratuities affect the benefits. All these three sections, 18, 19 and 20 have a similar effect and I shall discuss them all together.
    8. Section 27 is concerned with retirement annuities and will not be considered here.
    9. In my experience, the minimum benefit contained in section 18 mostly affected is withdrawals (and occasionally deaths) as opposed to all the other types of exit.
    10. The impact of this change will probably be greatest in the case of Defined Benefit ("DB") schemes as opposed to Defined Contribution ("DC") funds and these will be discussed in turn.
    11. However, before doing so, we will discuss a number of technical issues.
  3. TECHNICAL ISSUES
    1. There is no defined "effective date" so I imagine that the effective date is the date of the SI, namely 14th June 2002.
    2. I assume therefore that it will only apply to exits after 14 June 2002. This is a key assumption.
    3. A second, very critical, issue is whether the calculation is to be backdated to apply to accumulations paid before 14 June 2002.
    4. Backdating would obviously be a record-keeping nightmare and it is doubtful whether either the contribution details or the records of returns would still exist in most cases.
    5. Again, I assume that backdating will not be required and that the previous minimum of 4% per annum simple will apply to contributions made before 14 June 2002 and the new, probably higher, rates will apply thereafter.
    6. [I do have some concerns as to what the members' expectations might be].
    7. Some thought will need to be made as to how the two minima will work. For example, it might be advisable to store permanently the total member's contributions plus 4% per annum simple interest up to 14 June 2002. This question should be considered.
    8. The question as to how the "interest that would have been earned by the Fund" is to be calculated is not specified.
    9. Particular issues are whether unrealised capital gains should be included, whether a book value approach would be acceptable (or other approaches) and whether a hypothetical portfolio could be used.
    10. I assume that it will be at the discretion of the trustees, as it largely is at the present with DC schemes.
  4. FUTURE IMPACT: DEFINED BENEFIT FUNDS
    1. In Defined Benefit ("DB") funds the benefits payable on withdrawal typically consist (to this day) of the members' contributions plus either simple interest, compound interest or a formula based on multiplying an interest rate by the number of sears of service. The rates are typically in the range of 2% to 6% for each year of service.
    2. Often the withdrawal benefits were defined to be just greater than the statutory minimum.
    3. It is these very low rates which I imagine the Registrar is trying to redress and is the purpose of this amendment.
    4. Certainly the typical DB design, especially in these very highly inflationary times, represents a dramatic subsidy towards members that are retiring as opposed to withdrawing and has become increasingly difficult to justify to members.
    5. As is well known, in these funds, the benefits are defined and any increases in such benefits will in most cases automatically result in an increased cost to the employer.
    6. The amount of that extra cost will depend on the following:
      1. the extent to which exit benefits are increased by the SI;
      2. the number of such exits; and
      3. the extent to which this change is backdated; (see the earlier discussion).
    7. The actuary to your fund should be able to estimate such a cost, should you require it immediately.
    8. In many cases, an amendment to the rules of the Fund will be necessary.
    9. A further impact on DB funds is that it will strengthen the minimum benefits payable on discontinuance.
    10. Overall, I would expect this change to provide further arguments for employers to convert their Funds from DB to DC.
  5. FUTURE IMPACT: DEFINED CONTRIBUTION FUNDS
    1. Most Defined Contribution ("DC") funds provide a rate of return which is already based on the Fund's experience. In such cases, there should be no financial impact on the Fund.
    2. However, there may be some DC funds which provide a low rate of return to members with withdrawing benefits and I recommend that these Funds review their current rules and practice.
    3. Depending on whether your rules explicitly refer to the minimum or not, it may be necessary to make a rule amendment.
  6. CONCLUSIONS
    1. We recommend that each fund, and especially any funds which are still DB or have DB components, should:
      1. review their rules to see if any changes are necessary;
      2. review their administration procedures to see if any changes are needed; and
      3. in the case of DB funds consider whether the employer's contribution rate should be increased.
    2. We would naturally be delighted to assist with this process should you require us to do so.

This analysis will be posted to our web site which already contains a review of the legislation and circulars which have been issued this year.

However, we are writing individually because I am not sure to what extent internet access is available at our clients' offices.

A final caveat is that we are not lawyers and we are interpreting this legislation as actuaries and pension consultants.

M A HYDE

Actuary

Copyright: Pentact (Private) Limited, 2002-8
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