Why the Public Servants’ pension scheme should be changed

From 25/05/2014 Sunday Island

by R.M.B Senanayake



Last week I attended a `Sambhashana’ panel discussion organized by Transparency International Sri Lanka (TISL) at the auditorium of the Organization of Professional Associations (OPA). The theme of the discussion was ‘Pension – What Next?’

Mr. Joseph Stalin, the teachers’ trade union leader said that the government has devised a new method of paying pension gratuities of public servants through the banks.  Provincial Councillor Asantha Samarasinghe noted that the Minute on Pensions has legal status by Ordinance No. 02 of 1947 and the Pension Act of 1943. He pointed out any changes must involve amending the regulations in the Act.

The prevailing earlier practice was to grant this gratuity amounting to two years salary to pensioners at the time of their retirement and recover it by deducting a percentage as an installment of the pension payment over 10 years. Even then the amount recovered was only 60 per cent of the gratuity granted and the balance 40 per cent had been written off. He said the number of pensioners who have applied for gratuity has increased to around 14,000 a year. He disclosed that gratuity payment has been delayed since 2006 and pensioners have to wait for six to 12 months to obtain gratuity.

New system

Under the new system the bank will recover the full amount of the gratuity in 18 years along with interest at the prevailing bank rates. Planning of the new scheme has put on hold the payment of gratuity to around 14,000 pensioners for the past period of around one year. More than Rs. 10 billion is due to these pensioners. But the government, said Mr. Stalin, is deducting 10 per cent of their pension payment even without paying them the gratuity and this is a violation of their fundamental rights.

Mr. Ranugge, the Chief Executive of Transparency International, stated that the Treasury itself should borrow money from state banks and continue the pension gratuity scheme without transferring the burden of borrowing gratuity loans to the pensioners.

The financial burden of pensions

The Pension Department’s 2010 survey report shows that the number of permanent and pensionable employees in the public service was about 10 lakhs. It would keep on increasing each year since the present Government keeps employing unemployable graduates in the public service as an unemployment relief scheme. But we are under-going demographic changes which increase the dependent population (over 50 years and under 15 years) at the expense of the working population.  .

The Pensions Department has provided a forecast of the financial burden in its website as follows:

Public service pensions although paid by the State in the first instance are ultimately paid by the tax payers directly and indirectly. The government budget deficit for 2013 was funded by bank borrowing to the extent of 70% (CBSL Annual Report page 175). So more and more bank borrowing which is the equivalent of printing money, will eventually result in hyper inflation and/ or unsustainable balance of payments deficits leading to the collapse of the rupee. So the present situation where public servants don’t contribute anything to their pension liability while enjoying a defined benefit of so much (2/3 maximum) of the last salary is a huge burden on the people. It is also manifestly unfair by the people, the large majority of whom earn much less than the pensionable public servant - a case of the poor subsidizing the better off.

A non-contributory defined benefit scheme is not financially viable

Yes indeed the Treasury’s proposal arises from the lack of viability of the Non-Contributory Pensions Scheme for government employees. It has no money to pay the increasing commuted pensions.  

A public employee could accumulate up to 35 years of pensionable service and draw a commuted pension at the time of retirement and a monthly reduced pension thereafter until 10 years have passed when the original unreduced pension would be restored. The public employee does not have to make any contribution unlike in some other countries like Canada where the employee contributes 3% of his salary. We have a similar Widows and Orphans Pension Scheme where the employee contributes 4% of the salary.

Occupational pension schemes like the Public Servants Pension Scheme may be funded or unfunded;  defined benefit (DB) or defined contribution (DC). Our pension scheme is non-contributory and unfunded. The aggregate amount of pension’s payable for the year is voted each year in the budget. So it is not funded through a special fund to which contributions are made by the government. It is necessary to fund pensions so that the necessary funds to pay the pensions of the employees are readily available. As it is the pensions of state employees is paid by the taxpayers.  

Dr N.M Perera, the economist, realized that the State Employees’ Pension Scheme would drive the State to bankruptcy and abolished it. But economic illiterates among our political leaders restored it.

Defined benefit schemes

Under a DB system, the employer promises to finance a future retirement benefit for a large group of current and former (retired) workers. Under a Defined Contribution (DC), the employer makes current contributions to the retirement accounts of each employee. The size of the ultimate retirement benefit generated by a DC plan depends on the amount of savings and investment returns the fund is able to accumulate over the course of the beneficiary’s working life. The downside risk of unanticipated investment losses and the upside potential for unanticipated investment gains are shifted from the employer to the employee as in the EPF.

A DB scheme is one where the benefit entitlement is defined in some way by reference to employee earnings and length of service. So, he knows in advance what his pension will be - for example two thirds of his  final salary if he has 35 years service. The defined benefit (DB) pension plans provide for a fixed percentage of retirement income based on their peak salaries and service period. If there is a Fund, it requires the government to provide money each year to cover future pension payments.  If it is not funded, it will require increasing amounts each year from the budget. If funded, it will require the contributions to be varied from time to time in order to make sure that the fund can meet the level of benefits. This is the risk of a defined benefit scheme and it is not financially sustainable in our high budget deficit economy. So we need to do away with defined benefits and have benefits that depend on contributions and returns thereon

Defined Contribution schemes

Skyrocketing state pension costs have been a major factor in the fiscal crisis affecting several governments in the developed world and they have taken action to reform them. They have been converting them to contributory pension schemes where the employee also contributes a part of his or her salary. The amount to be contributed will have to be worked out by an actuary taking into account the life expectancy and the age distribution of the population.

Even with funded contributions, the DB system is crisis prone because earnings during bull markets cover employer contributions, while losses during bear markets force governments to drastically increase contributions. Since bear markets usually coincide with recessions, funded DB pension plans force governments to spend more when they are least able to afford it. So defined benefit pension schemes are not affordable at all.   

In the interest of fairness to the people, even at the expense of fairness to the public employees, it is necessary to change our public service pension plan to a contributory scheme with non-defined benefits. Generally   4% may be sufficient and the Government will match it with say 5% but the Fund will have to be invested by professionals to earn the maximum return.

We must shift from the current defined-benefit pension entitlement to a defined-contribution retirement savings plan.  It should be funded jointly by employer and employee.  The percentage of employee salaries that employers must contribute to the pension fund is based on actuarial assumptions concerning the number of active and retired workers; the projected salaries, pensions and life expectancies of retirement system members and their beneficiaries; and the current and projected rate of return on pension fund investments. Retirement systems must be fully funded and enough money kept in the Fund to meet all current and future pension obligations.

Instead of a single common retirement fund, a defined-contribution plan consists of individual accounts supported by employer and employee contributions. This is similar to the private sector Employees Provident Fund.  These contributions should not be subject to income taxes. Funds in the accounts may be invested by professionals such as Certified Financial Analysts in a combination of stocks and bonds.
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