THE ADMINISTRATION AND FUNDING OF PENSION SCHEMES

T. A. MURRAY

PENSIONS MATTERS HAVE been widely discussed in recent years and the rapid development in this sphere in the post-war years is well known. Social scientists, and others, have concerned themselves particularly with the amount and nature of thc bcnefits, while economists have looked to the impact of the growth of pension schemes on the national economy. The science of the actuary has involved him in all the aspects of the matter, particularly in the technical features and the all important question of cost. Research and discussion has been very active in the United Kingdom, two recent major contributions being the work of the Phillips Committee on “The Economic and Financial Problems of the Provision for Old Age” and the study of “The Growth of Pension Rights and their Impact on the National Economy”, which was made by a group of actuaries at the request of the Councils of the Institute of Actuaries and the Faculty of Actuaries. To come closer home, Mr. G. Rissik of thc S.A. Reserve Bank recently read a paper entitled “The Effects of Pension and Provident Funds and their Investments on the National Economy” at the conference of the Association of Pension and Provident Funds, which was held in Johannesburg.

There is one important aspect of Pension Funds, however, that often escapes the attention it merits: it is the fundamental question of how a pension scheme should be administered. The two principl ways of achieving this are by means of an internally administered scheme or by arranging the scheme with a Life Office. Discussion of this question is to be the main theme of this article. It is interesting to note that a similar subject is on the agenda for the International Congress of Actuaries in America next year.

I propose to consider firstly the individual items which influence the actuary in his choice of the basis of calculation and which thus form the basic foundation of a pension scheme and subsequently I intend to review the interaction and joint elTcct of these forces upon the picture as a whole.

Before discussing the individual items it should’be stressed that we are dealing with very long-term estimates and that the whole picture is coloured by the fact that the elements under consideration are iafluenccd by factors remote in time and unknown in quantity. The principal components of an actuarially computed pension contribution are mortality, interest and expenses, and inherent in the computation are estimates of the future course of these components which sometimes extend fifty years or more into thc. future. In the field of Pensions business the skill and ingenuity of the actuary are taxed to the full.

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MORTALITY For many years mortality 113s continued to improve steadily and in recent

times the improved standards of living and the progress and discoveries of medical science have led to increases in longevity that are little short of remarkable. It is not generally appreciated that this very desirable state of affairs is having an adverse effect on the funds and finances of privatcly adniinistered Pension Funds and on the annui ty portion of Life Oflice busincss-to the extent that the improvement in longevity exceeds expectations. While the trend of mortality rates is moving against pension and annuity business, it is moving in favour of the Lifc Offices in the conduct of their assurance business.

All calculations involving the contingencies of human life stem primarily from the theory of probability-the so-called Law of Averages-and, fundamentally, the greater the number of'lives involved, the closer the theory applies; conversely, the fewer the numbers to which the theory is applied, the greater is the possibility of deviation from the expected result.

Accordingly, the degree of stability to be expected in the mortality experience of any particular pension scheme is very largely a function of the number of lives involved in the sclienie in question. It is not possible to generalise. but even a group of lives of, say, two or three hundred employees may be considered as being too small for stability to be expected in their mortality experience.

On the other hand, arising from their larger scale of operations, the leading Life Offices are in a position to average their experience over a very great number of lives assured, and are thus able to attain a correspondingly greater degree of stability in their mortality experience.

This stability, being a function of the combined experience of the Life Office, is unaffected by the number of lives involved in any individual scheme. In this way risks, which might be individually catastrophic if allowed to fall where they arise, arc pooled and averaged in a bigger fund, large enough to take i t without undue strain. In addition, a buffer is provided for the Life Office by the fact that a mortality experience that causes losses on mortality in the conduct of annuity and' pensions business, can be set off against profits in the conduct of life business.

INTEREST The broader basis arising from large funds and probably greater skill in the

matter of investment, should in most cases enable the Life Offices to secure a higher rate of interest than a private fund. Life Ofices have many millions of pounds that have to be invested every year. They must', of necessity, therefore, be adequately equipped to invest the funds involvcd and to determine economic and market trends in advance. Owing to the very great volume of their invest- ments, the leading Life Offices are able to command outside sources of information that are not open to smaller investors, and are able to spread their funds more widely over the various classes of investments than smaller investors could do.

Investment is a regular daily function of a Life Ofice, and its machinery is particularly suited to the trustee nature of the investments pertaining to the

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funding of pension schemes. In addition, money is not allowed to lie idle. A committee of an internal fund, mecting at intervals and whose members’ normal functions do not include the investing of money, could not be expected to achieve the same facility and succcss in administering the investments of the fund, and will generally, at any point of time, have a larger proportion of their funds un- invested, which must reduce the maximum interest yield.

EXPENSE Owing to the large volume of business transacted by Life Offices, expenses of

administration are much reduced through this business being handled, in bulk wherever possible, by up-to-date accounting and calculating machines, instead of by niore expensive clerical labour. A good example of this is the recent introduction of electronics into the insurance industry. The speed and field of operation of this new device is remarkable and, in the case of a large South African Life Office, it has been estimated that an electronic installation that was recently ordered would do the work of some 400 clerks.

I t remains true that: “A great merit of group contracts is the relatively low cost at which they can be administered-including acquisition expenses, about 5 per cent of the prcmiums”.l “Group contracts” is, of course, a description of a popular form of Life Ofice pension scheme. The comparable figure in South Africa is estimatcd to be under 5 per cent of the premiums paid.

It is doubtful whether the expense ratios of internal schemes will be found to be much below 5 per cent of the contributions paid, particularly when account is taken of the following items: the legal and actuarial fees in establishing the scheme, an annual audit fee and a periodical actuarial valuation fee together with the cost of the general management and of the investment and supervision of the funds.

OVERALL POSITION

Having dealt with tlic principal items seriotini it would be as well at this stage to considcr the combined effect of all thcsc component parts.

The first question to occur to employers would probably be the cost of the alternative forms of pension arrangements. For similar benefits and similar costs, pension schemes underwritten by the leading Life Ofices are at least as competitive as internally-run pension funds. In addition, tlie cost of the Life Office scheme is inherently more stable than that of the internal fund where fluctuations in experience Fall largely upon the employer and deficiencies have to be funded. There is, further, the often obscured liability of the employer who has given an intercst guarantee to tlie internal fund. If intercst rhtes fall below a certain mark the deficit has to be made up and this can rcach substantial proportions. This interest guarantee is sometimes referred to as a “hidden subsidy”.

The great strength of the Life Ofice scheme lies in the element of guarantee and security that it provides. The importance of the security aspect in pension schemcs is self-evident and “It may safely be said there is nothing in the commercial

I . Extract rrom the Prwidcnlinl Address of the President of the Instilute of Actuaries in 1952.

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world which approaches even remotely, the security of a well-established and prudently managed insurance ollice’*.l

It is not without importance that a Life Ollice’s pension scheme entails less administration by the employer. I will not go into detail exccpt perhaps to mention that only an institution which has had occasion to invest and keep invested at a satisfactory rate of interest trust moneys of this nature, can really appreciate the amount of work entailed therein, and this is only one aspect of the adminis- trative work.

It is sometimes contended that some internal schemes are more flexible than that of a Life Office, particularly in respect of ill-health pensions and in respect of relating the ultimate pension to the salary received just before retirement age. However, provision can easily be made under Life Ofice schemes for pensions directly related to the final salaries. Early retirement pensions are also provided for, although normally on a less generous basis than under the type of internal fund concerned. The basic difference is this:-in the internal fund assumptions arc made about the rate of ill-health retirement and the trend of salaries in future (the aspect of inflation being ignored) and the liabilities are funded in advance on these assumptions. There is a danger of an inclination to retire people early or to augment their pensions by means of increases in salary granted late in their working life-time, as the cost is not immediately obvious and is in any case borne by the pension fund . In the case of the Life Ofice scheme, the assumptions mentioned above are not made. As and when salary increases are granted, the corresponding pension is funded and the cost is known immediately. It is impracticable for a Life Ofice to accept the risks which arise from causes not susceptible to rexionable actuarial assessment and therefore early retirement pensions arc confined to the present actuarial equivalent of the pension already accrued but only due to be payable from the normal pension age. Usually this gives a lower pension on early retirement than under the internal fund but the pension can be supplemented by the employer who, at the same time, will be ful ly aware of the financial implications. It might be mentioned here that benefits have to be paid for in any case and that the point at issue above is not so much the extent of the benefits as the incidence of the cost thereof.

Estimates of the future mortality, interest and expenses are made on the conservative sidc in fixing the rate of contributions under the internal scheme and the premium rates under the insured scheme. Any profits arising from this source fall to the fund under an internal arrangement, whereas, under insured schemes the position is as follows. In the first place the profits, if any, under consideration are those arising from the conduct of the’business as a whole and not from the particular experience of any individual scheme. With-profit schemes gain their proportionate share of profits in the form of bonus additions. Non- profit schemes do not benefit directly and immediately in the form of bonuses,. but indirectly and in due course by way of reduction in premiums when this is indicated by the experience.

2. Aupuslus de Morgan. quoted in the Presidential Address oC the President of the Faculty of Acluanu in 1954.

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Losscs caused by varying experience of members, pensioners, values of securities and levels of interest are borne by the fund under an internal scheme, whereas they fall on tbc Life Oflicc under thc insured scheme. The Life Office looks to the conduct of its business as a whole and ignores the fact that a n individual scheme has operated at a loss. If the conduct of the business as a whole reveals a loss, an upward adjustment of premium rates will follow for fresh contracts, while tlie tcrms of existing contracts remain undisturbed.

Where the number of employees is sufliciently large, and the employer is able and willing to guarantee the solvency of a fund and is financially strong enough not to be embarrassed by a certain amount of fluctuation in cost and has the scrviccs of financial experts ordinarily a t his disposal, the case for an internally administered fund is strong. For example, the pension schemes of the Civil Service and the Banks are normally internally administered. The majority of cases, howevcr, fall outside this pattern and, in varying degree, are better suited to schemes arranged with a Life Office.

I t is estimated that in South Africa as well as overseas, in so far as commercial firms are concerned, there are many more pension schemcs underwritten by Life Offices than there are internally-run pension funds. One of the principal reasons for this is the consideration that the employer’s main concern is his business, not the specialised problems of finance connected with superannuation to which he might be disinclined to devote the necessary time or of which he may lack the necessary knowledge.

There arc no up-to-date statistics available for South African business but the following figures, which have been extracted from the Economist, show the tremendous increase in pension business conducted by Life Offices overseas:-

ASSURED PENSION SCHEMES IN TIE UNITED KINGDOM^ In Force on December 31st

1951 1952 1953 OROUP m e ASSURANCES+ Sums Assured (E mm.) . . . . . . 532.6 643.7 745-1 Premiums (E mm.) . . . . . . 11.9 14. I 16.2

Pensions p.a. GROUP PENSION SCHEMES

(i) Active (E mm.) . . . . . . 3-1 3.8 4.5

Premiums (E mm.) . . . . . . . . 41.8 50.2 55.3 (ii) Deferred ( E mm.) . . . . ~. 140.8 175.9 202.9

SCHBMFS BY INDIVIDUAL POLICIES Sums Assured (E mm.) . . . . . . 239.2 305-0 356.0 Pensions p a .

(i) Active (f mm.) . . . . . , 0.9 1.0 1 . 1 ( i i ) Deferred (E mm.) . . . . . . 36.6 43.1 48.5

Aniiual Preniiums (f mm.) . . . . 17.7 21 * 6 24.6 Including group endowment auuranus.

3. Figures published by the Life OWces’ Association and the Asxristed Scottish Life OWm.

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1954

859.7 18.6

5 . 3 226.9 63.2

409.0

1.2 52.3 27.5

T11E S O U T H A F R I C A N J O U R N A L O F E C O N O M I C S

The following table gives an idea of the growing proportion of pension business:

Year Total Premiums under Pension Scheme Business

as at 31st Decembcr I949 f47.300.000 1950 f55,300,000 1951 f 7 1,400,000 1952 f 85,900,000 1953 f96, I00,OOO 1954 f 109,3OO,OOO

Pcrcentage of Total Annual Premiums

25.9 27.6 31.5 33.9 31-5 34.4

The fact that the percentages applicable to business in existence are increasing, indicates that an even larger proportion of New Business premiums arises from "schcme" business.

The pcnsion business underwritten by South African Life Ofices may not form quite as high a proportion of the whole as it does overseas, the chief reasons being that the United Kingdom is more highly industrialised and the additional incentive of the relief allowed from the very high rate of tax. However, it is unlikely that the proportions applicable to South African life business are very much below those shown for the United Kingdom and, in any case, there is no doubt that the sharply increasing trend overseas has been fully matched in South Africa.

In conclusion, the Pension Funds Act, 1956, will rigidly control internally administered pension funds but provision is mode for exempting pension schemes underwritten by Life Offices as the Life Offices are already themselves controlled. Perhaps the most significant feature of this control will be the requirement that a certain minimum proportion of the assets are to be invested in specified securities. For those Pension Funds that have been attracted by the higher yielding investments which fall outside the new prescribed range, this restriction will impose a sensible contraction in income. In particular, the asscts of a pension fund may not be invested in thc business of the employer in future.

With all these facts before him, no light decision rests on the employer instituting a pension scheme, in deciding between an internally administered scheme or one underwritten by an cstablished Life Oflice.

Cape Town.

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