PRA 2014 and management of private sector gratuity and pension schemes (1)

The Nigerian pension industry currently consists of three pillars, namely, the public sector Pay-As-You-Go (PAYG) defined benefit (DB) schemes; private sector defined benefit (gratuity and pension) schemes, and the contributory pension schemes (CPS) under Pension Reform Act (PRA) 2014 which repeals the PRA 2004. Depending on a person’s situation, a retired person may be entitled to benefit(s) from either the first, second, or third pillar, or from the first and third pillars, or from the second and third pillars, but not from all the three pillars.

Impact of PRA 2014 on existing private sector schemes

The enactment of PRA 2014 has an immediate effect on the existing defined benefit and defined contribution schemes operating in the Nigeria pension industry prior to the introduction of CPS.

Defined benefit pension schemes

Section 50 (1)(a)(d) of Pension Reform Act (PRA) 2014 states that any defined benefit pension scheme in the private sector existing before the commencement of the Act may continue to exist provided that the pension scheme shall be fully funded. Furthermore, every employee in the existing scheme shall be free to exercise the option of coming under the new contributory pension scheme. The existing scheme shall be closed to new employees and such new employees shall be required to open a retirement savings account (RSA) under CPS (Section 50 (1)(h) of PRA 2014). This implies that no new defined benefit pension scheme will be established by any employer after the commencement of the PRA 2004. Thus, the unfunded pension schemes will not be allowed to exist.

Defined contribution schemes

Section 50 (1)(a) of PRA 2014 also requires that for any existing defined contribution scheme in the private sector prior to the commencement of the PRA, the contributions in favour of each employee including the attributable income shall be computed and credited to a retirement savings account (RSA) opened for the employee under CPS.

Defined benefit gratuity schemes

The enactment of PRA 2004 led to the winding-up of many employer-sponsored gratuity schemes in the private sector in order to start the new CPS with the aim of reducing costs of running two schemes at a time. However, the Act did not actually prevent any employer that had a gratuity scheme prior to the commencement of the PRA or that desires to adopt a new gratuity scheme from establishing a Gratuity Fund for its employees subject to the terms and conditions of their employment, in addition to the compulsory contributions into the new CPS. Thus, establishing a gratuity scheme is in line with the provision in section 4 (4) (a) of PRA 2014, that “an employer may agree on the payment of additional benefits to the employee upon retirement” by whatever name it is called (gratuity, severance or terminal, lump sum, long service award) over and above the employee’s retirement benefits stated under section 7(1) of PRA 2014. The above implies that the gratuity schemes operating in the private sector are opened to new employees.

Rationale for improvement in management of private sector schemes

The main objective of PRA 2014, as far as private sector schemes are concerned, is to establish uniform rules, regulations and standards for the administration and payments of retirement benefits as and when due (section 1 (a)(c) of PRA 2014). Thus, this objective is aimed at improving the management of private sectors. In addition, there are other reasons why scheme sponsors would seek to improve the management of their schemes.

Meeting employer’s objectives

Regardless of the size and the number of private sector schemes operating in the pension industry, there is need to improve the management of the schemes in order to meet the employers’ objectives (both financial and non-finance related) in setting up the scheme. The employers’ objectives include but not limited to the following: maximizing profits by attracting and retaining the services of good quality employees; providing benefits that are at least in line with those offered by competing employers; and controlling the costs of financing the benefits.

Exposure to financial risks

There is a confluence of factors that has prompted scheme sponsors to improve their management of the financial risks in DB-funded schemes: pension under-funding and its persistence due to a decline in long-term interest rates; effects of increased longevity on scheme costs; effect of increase in accounting and statutory regulations; and the sponsor’s attitude to risk.

Increase in private sector gratuity schemes

In practice, the usually non-contributory DB gratuity schemes in the private sector have become popular among the employers in recent times. This popularity can be attributed to the fact that the employer’s contributions to fund the gratuity benefits may be considered as the additional voluntary contributions (AVCs) over and above the compulsory minimum contributions which would have been paid to provide additional retirement benefits for its employees under CPS. This is applicable where the employer decides not to take sole responsibility of funding the CPS (section 4 (4)(b) of PRA 2014).

Furthermore, an employer would prefer to provide AVC to fund gratuity benefits in the private sector instead of paying it into employees’ CPS because of: easy accessibility of gratuity benefits at any point of exit than benefits from RSA under CPS which has an age limit on withdrawal of benefits; investments of the gratuity funds would be under the control of the employer; and gratuity income may be subject to lesser variability than retirement income from CPS.

As the gratuity schemes are opened to new employees, they are also likely to increase in size and number over time, and therefore there will be a need to improve their management of the financial risks facing them.

Challenges of managing private sector schemes

No new DB pension scheme designs after PRA 2014: The existing pension schemes in the private sector are mainly designed as balance of cost final salary schemes which are funded. In this case, the employees make defined contributions and the sponsor pays the remainder of the unknown cost of providing benefits. The contributions are payments towards the estimated cost of the benefits. The PRA 2014 prevents new private sector DB pension scheme designs to be made in the future but only the amendments to existing DB pension schemes are required (such as reduction of benefits because of insufficient funds available to provide the pension benefit).

Lack of actuarial inputs in gratuity scheme designs: Gratuity (which is a lump sum benefit) can be defined as a part of salary that is received by an employee from his/her employer in gratitude for the services offered by the employee in the company. In practice, the most common DB gratuity scheme designs existing in the industry after PRA 2004 are non-contributory in nature, the level of benefit relates to final salary and length of service with the employer payable on death, disability, retirement or resignation. The accounting regulation, IFRS as set out in IAS 19, requires that defined benefit schemes may be unfunded or they may be wholly or partly funded. Thus, many employers design and operate the gratuity schemes on an unfunded pay-as-you-go basis due to lack of actuarial involvement. This is against the provision in the PRA 2014 that private sector pension schemes should be fully funded at all times (Section 50(1)(a) of PRA 2014).

Increase in employment costs: The increase in employer’s compulsory contribution rates from 7.5 percent to 10 percent in CPS (section 4 (1) (a) of PRA 2014) has significantly increased the employment costs and due to affordability companies may need to review the levels and design of their total employee benefit packages (e.g., gratuity schemes). This review would pose a greater challenge to employers without an actuarial input.

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