What’s so complex about pension funds that only a few get it right?

It’s extremely rare to hear about a pension fund that is doing well. According to the Melbourne Mercer Global Pension Index, an annual report that compares different pensions around the world, not a single country in 2017 qualified as having a “Grade A” pension — “a first class and robust retirement income system that delivers good benefits, is sustainable and has a high level of integrity”.

But wait, that’s not all. Denmark and Netherlands were classified as “Grade A” in 2015 and 2016 — I was actually quite hopeful seeing them there as a role model for other country-based pension funds.

What’s so wrong about pension funds? And why should it matter to you? Those are the two questions that I intend to answer in this article, by identifying three key issues and how they relate to your pension.

First, pension funds, at a global level, are treated as lump sum, where all contributions go into a single fund, and from there onwards to investments and to pay retirees. In other words, pensions are not individualised, where a contributor to the fund could decide on their contribution level, their desired return on investments, and ultimately how much pension payout they would like to receive in the future.

This is what a defined-contribution pension plan resolves. It basically allows an individual to track their contributions and returns on investments, showing what has been so far accumulated in the pension account. Knowing how well your pension is doing allows you to do one of two things (or both): one, Adjust your contribution level and desired returns if your existing pension plan allows it, and two, invest into privately managed plans to reach your retirement goals.

Some pension funds pay salaries in perpetuity with disregard to average life expectancy. This is especially important for many countries in the region since pension payout can be passed on as inheritance, where the female partner continues to receive pension payouts and, possibly, even the offspring. Why is this a problem?

Because no matter how well you plan for future pension payouts, and even if you take future life expectancy into account, it will be extremely difficult to precisely identify when a pension payout will stop. A solution here would be a system similar to that of Singapore, where you decide on what amount you would like to see in your pension account when you retire.

The amount is then paid to you in whole or is divided over the difference between your age at retirement and average life expectancy in the country — pensions must have expiration dates.

The third issue is that pension funds are not necessarily linked to inflation. Why should you care, right? Allow me please to explain.

Inflation undercuts your ability to consume today by getting less for the same amount of money, and future inflation does the same. For example, $100 in 30 years will not get you what $100 can get you today, but a $100 growing at 5 per cent a year presumably can.

So, you will need your pension to grow at a rate that makes up for that loss in consumption power over the years, and that’s where return on investments come into play.

Should you be concerned? Yes, because come retirement time, and the pension fund that you have been contributing to might be severely and terminally underfunded, or it may be altogether nonexistent.

Okay then. What does an ideal pension look like? An ideal pension is one that where contribution level and desired return on investment are selected based on desired future pension pay out, where average life expectancy is factored in and updated whenever needed, and where your contributions and returns are inflation protected.

The last thought that I want to leave you with: why did underfunded pensions become the new normal for countries? (Hint: budget deficits).

The writer is a UAE based economist.