Planning With Retirement in Mind

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Published on September 10, 2007
BusinessWorld Wealth Manager Section

For many Filipinos, retirement income will come from three sources: personal savings, social security, and employer-sponsored retirement savings plans.

Interest rates on personal savings are at an all-time low and many lack the knowledge of where to invest their money to obtain a better-than-average return. On the other hand, many are concerned that social security may not be sufficient as a retirement vehicle. All of these stress the importance of employer sponsored retirement plans as a means of providing retirement income.

TYPES OF RETIREMENT PLANS

Companies may choose from a Defined Benefit (DB) plan, a Defined Contribution (DC) plan, or a Hybrid Plan.

DB plans define its benefits at separation in terms of the salary and years of service of the employee. Currently, many plans provide a benefit of 150% of the employee’s final monthly salary for every year of his service at retirement.

Under a DB plan, the company intends to make sufficient contributions to the plan so that the employee receives the specified plan benefit. Company contributions are determined frequently by an actuary.

DC plans define the contribution rate of a company to the individual account set up for each employee in the plan. Company costs are therefore more predictable for DC plans. Contribution rates are typically expressed as a percentage of the employee’s salary. That amount, plus investment gains or losses, will be paid to the employee upon retirement or separation.

The individual account balance of the employee under a DC plan is analogous to his typical bank savings account in that it has a contribution and an earnings sub account. The company informs the employee of the accrued benefit in his account balance by issuing periodic individual statements. As a result, the employee directly realizes how much is being contributed on his behalf and how fast his benefits are growing.

On the other hand, there are no individual accounts under a DB plan. Because of this, there are no individual statements provided to the employees.

Hybrid plans have a combination of both the DB and DC feature.

TAX ADVANTAGES

To maximize the benefits of a retirement plan, the company registers the plan with the Bureau of Internal Revenue for tax qualification. Under this status, the income of the retirement fund is free from tax. Furthermore, the benefit of a retiring employee who is at least age 50 and has served the company for at least 10 years is also free from tax.

The BIR also provides an incentive for companies who sponsor a tax qualified retirement plan by allowing the company to deduct its contributions from its taxable income.

DEFINED CONTRIBUTION PLANS

There is a slowly growing interest toward DC plans primarily because it allows a company to manage its cash flow.

A number of companies who already have an existing DB plan have introduced a DC plan as their primary retirement vehicle. They have done this by “freezing” their DB plan so that it no longer accepts new members or no longer allows accruals due to service of its existing members.

A number of companies have also added a supplemental DC plan to their existing retirement plan as a savings feature. The DC plan enables the company to provide a means for its employees to save for retirement by allowing the employees to contribute to the plan.

• Employee Participation. By contributing to the plan, an employee may enjoy a better than average return on his investment. The Watson Wyatt Survey on Investment Performance of retirement funds in the Philippines showed that the performance of retirement funds over the last 5 years is as follows :

Aside from the higher returns of retirement funds, a participating employee would also enjoy the tax exempt benefits under the plan’s tax qualified status.

• Matching Employer Contributions. Many companies match their employee contributions to the DC plan to encourage employees to consistently make contributions that will provide a satisfactory level of benefit at retirement.

As a practical matter, the level of company contributions is a financial decision. If the company is starting a plan, it may want to choose a modest contribution formula as it is difficult to project the company’s likely cost. It is much easier to raise the match later than to lower it.

To illustrate how considerable employee and company matching contributions could grow to at retirement, we have taken an employee aged 30 with a monthly salary of P25,000. We have assumed that salary increases would average 8% per year up to retirement at 60 and that the retirement fund would earn 10% per year, the lower quartile return in the Watson Wyatt survey. Furthermore, both employee and company contribute to the fund 2.5% of the employee’s monthly salary starting age 30 up to the employee’s retirement at 60.

The table below presents the resulting company and employee accounts at early retirement age of 50 and at normal retirement age of 60.

From the table, the total retirement benefit of the employee at age 50 is P1,625,600.

At age 60, his total benefit will be P5,810,400. Of this amount, the employee has contributed P849,600 over 30 years, which in turn has earned more than P2 million over that period. His contributions have also generated an additional retirement benefit of P2.9 million from the Company’s Account.

KEYS TO A SUCCESSFUL PLAN ADMINISTRATION

To ensure the success of a retirement plan means to ensure proper plan administration.

From our experience with many large companies, a prudent process should be followed when selecting investments. The company should continue to monitor, at least semi-annually and with the assistance of an independent expert, whether the funds are prudent. Furthermore, contributions need to be invested promptly and investment transfers or reallocations need to be executed accurately.

A retirement plan also needs to be communicated well to employees on an ongoing basis. The communication program should try to motivate employees to make contributions in line with their goals at retirement and to educate them on investment fundamentals.

As in everything else, engaging employees to participate in planning their future can spell all the difference.

Maylene L. Pascual is a Consultant for the Benefits Practice of Watson Wyatt Worldwide. Watson Wyatt is the trusted business partner to the world’s leading organizations on people and financial issues. For more information about Watson Wyatt’s Benefits Practice services, please contact Ms. Maylene L. Pascual at maylene.pascual@watsonwyatt.com or call 841-5100.