The govt is finally trying to fix Pakistan’s increasingly worrying pension problem. Is it too little too late?

The federal pension bill exceeds Rs 1 trillion mark. What are the reforms being implemented, and are the measures strong enough given how bad things have gotten?

A massive federal budget worth Rs 18.88 trillion was presented in the national assembly by the finance minister on the 12th of June. While there are many features of this proposed budget that have raised eyebrows, one thing that has been the subject of public debate for the last six months is the pension bill.

Over the last five years, the federal pension bill has ballooned by almost four times and has become a growing concern for the lawmakers. However not much has been done to alleviate the national exchequer of this high cost. The estimated amount proposed in the federal budget for FY25 is Rs 1.014 trillion, marking a 26% increase from the previous year’s budget.

Over the last six months, the government has been touting a series of reforms that will presumably take place to alleviate the pension burden. A similar stance was taken by the finance minister Muhammad Aurangzeb in his budget speech. He mentioned a three-pronged strategy in line with the international best practices; however, both the speech and the annual budget statement was devoid of the details on this strategy.

In the same breath, the finance minister also announced a 15% flat increase in the pensions of government employees. While this is merely a corrective measure to catch up with inflation, no difference in increase between lower and higher grade retired officers was announced. Nominally, this increase alone, adds Rs 122 billion or more than 12% to the pension bill.

To contextualise this, we first have to look at the problems that plagues the revenue account in the form of pensions. 

Summing up the proposition 

The new proposals presented by the Finance Minister hint towards a three pronged approach in order to address this issue. One of the biggest expenses that the government gives out on an yearly basis is the pension funds to its ex-employees. The pension system of the country is broken to be frank. As an employee of a private organization, a worker will see his salary after a part of it has been deducted in the form of provident fund contribution. This is known as a contributed fund where the employee contributes himself into the pension fund. 

The company can look to match his contribution but the key fact is that these are funded pension funds which have something coming into them. The way the pension system is designed in Pakistan’s public sector, most of the pensions are unfunded. Meaning for all the government employees from Grade 1 to 22, none of the employees see any of their pay deducted when they get their salaries. So how does the system get funded?

It is the government which ends up paying the whole pension. Consider an employee workforce of 1,000 people. Once these people retire, the government has to pay for the pension of all of these employees the next year. The next year, as more employees retire, the expenses increase and this cycle keeps on going. Once cost of living adjustment and increments are added of roughly 15% per year, the cost balloons out of control.

There is also a complication that the pension system is not monitored and designed in such a way that once the deserving person passes away, his wife becomes entitled to this pension. Once the wife passes away, the daughter or son becomes entitled and the pension expenses keep getting inflated. This is an unlimited burden on the exchequer and has the potential to snowball out of control.

The government has come up with three parts of the solution. The first part is to follow international best practices and to reform the system which is expected to restrict the pension liabilities in the coming decades. The exact specifics have not been given but it seems that some of the controls of this scheme will be tightened to address this. The second part of the scheme would be to have a contributory pension scheme for the new employees. As these employees are part of the new system, they will contribute into the scheme which will make this scheme fully funded. This will bring the practise inline with the private sector practises and will cost less to the government. Lastly, a pension fund will be created which will look to address the liability of the company.

The idea seems solid at this stage and will cut down much of the burden which is currently on the government solely. The scheme will try to bring it in line with the public sector that exists and will look to reduce wastage and slack that has been built into the system. Lastly, having a pension fund would mean that these contributions can be invested. A conservative fund can park these in a bank account to earn a steady return while some of these funds can be diverted to the mutual fund industry which will benefit the capital markets as well. The return earned on these funds will also compliment the pension fund without being costly for the government. 

The origin of the problem 

To get to its root we go back to 2009, when the government, for the first time included future retirees in the receivers of the increment awarded in 2009. In the following years, the same act was repeated more than 6 times. This means that any increment in these 6 terms was to be added to the pensions of not only the previously retired officers, but also the officers that were to retire after it. 

The step compounds increments for retirees, leaving service after 2020 for up to 6 times even before any of the latest increment is added to their basic pension. This causes the pension figures to balloon to the levels that they are currently at. It is important to note that even if the government does not make future retirees a party to the current increments, the 6 increments in the past can not be undone in a budget document.

However that is just the tip of the iceberg, there is precedent of such policies being enacted in various parts of the world but in most of these cases, the pension of retirees is funded by a pool of money, contributed by either both the employee and the government, or in some cases just the government, over the years of the employee’s service. Basically a pension fund.

Pakistan on the other hand follows a version of the defined benefits in pensions that demands the disbursement directly through the revenue account. Most of the developed world works on either a defined contribution model or a funded defined benefit. From this explanation it seems that the only way in which Pakistan can reduce its pension expense is by travelling back in time by at least 20 years. However, all is still not lost. The country can still offset some of its pension liability by funding it through a pension fund that incrementally increases in size.

Last year, the federal government announced the setting up of such a fund by setting aside Rs 10 billion. As the year progressed, Pakistan could not follow up on its overly optimistic budget, resulting in the slashing of the fund amount by Rs 5 billion. Even with the remaining Rs 5 billion, the setting up of a fund remained a topic of ambiguity amongst other bigger concerns. The government has pledged to add another Rs 10 billion to that fund in the FY25 budget.

It is important to note that to make a sizable dent in the pension bill, even in the short-term, Pakistan needs not 10, not 100 but at least a Rs 1,000 billion fund, an amount that no politically sane government can afford even half of.

With the current pension bill at almost 6% of the estimated total revenue and 8% of the estimated tax revenue, the government might just have to revise the funding sources of this revenue account expenditure.

Not to mention that with a flat 15% increment, the pension for 17-22 grade officers would increase at a much higher rate. Not to mention the compounded effect of these increments takes the pensions of some of the retired officers to an obscenely high level.

The reforms

As Pakistan was approaching the announcement of its FY25 budget, the escalating pension liability was a critical issue for the nation’s fiscal health. The finance ministry had already shared a comprehensive pension reform program with the International Monetary Fund (IMF) to curb the burgeoning pension expenditure, since the consolidated federal and provincial pension spending was projected to increase by over 20%, from Rs1.252 trillion last year to Rs 1.5 trillion plus this year.

Keeping that in mind several reform points were raised which are as follows.

Firstly, future increases would be based on either gross or net values at retirement time, indexed to the Consumer Price Index (80% of the CPI over the past three years), capped at a 10% annual increase.

Secondly, while government employees could currently retire early with full benefits, this would be discouraged in the future, with penalties ranging from 3% to 10% imposed on early retirees.

Third, pensions would be determined by averaging the salaries of the past 36 months, resulting in a lower pension amount. Fourth, the current commutation/pension ratio of 35:65% would change to 25:75%. This means that the lump sum amount taken at the time of retirement would be increased, relieving the government from a long term financial liability  Fifth, the option to restore full pension after a certain number of years will be  discontinued.

Sixth, the current defined benefit model, fully funded by the government, will transition to a pension fund model, as planned by the previous government. 

Another few significant changes included the stipulation that if a deceased employee’s spouse is also a government employee, the spouse would not receive a pension. Additionally, rehired retired employees would have to choose between pension and salary. The reforms also propose indexing pension increases to the Consumer Price Index, with a maximum allowable increase of 10% per year.

But according to media reports earlier this year, even these measures faced resistance from the Establishment Division, which argued that they would disadvantage and discourage civil servants. As a result, these reforms were not implemented.

The reform initiative, therefore, ended up to be nothing but a reincarnation of the three measures proposed by ex-finance minister Ishaq Dar in the budget for the FY24. This is the very “three-pronged” strategy presented by Muhammad Aurangzeb in his budget speech. 

One new step that the government has however announced is forming a contributory fund for newly appointed federal employees. The time it would take to realise this step however, is at least 35 years, if one is optimistic.

It is important to point out that the public-sector pension liability now exceeds government spending on development projects, underscoring the urgent need for sustainable reform.

Taimur Khan Jhagra, a former finance minister of Khyber Pakhtunkhwa, launched a contributory pension scheme for provincial employees hired since July 1, 2022, marking a significant departure from traditional practices. He notes that India adopted similar reforms in 2004 under a World Bank project, which failed in Pakistan, leaving a Rs1.5 trillion pension bill for FY24, a third of which is military pensions.

Jhagra while talking to the media warned that without reforms, the pension bill is projected to grow at 22-25% annually for the next 35 years. He underscores that the national pension bill has increased fiftyfold over the past 20 years, doubling approximately every four years. This exponential growth threatens to bankrupt the pension system within a decade if left unaddressed.

“The new budget has announced pension reforms but they should have mentioned how this started off in KP, and it would have helped had they followed our model. The next step was putting new employees on a contributory pension scheme. But these employees won’t be getting pensions for 40 years. What of all the employees today? Their pension is still fixed,” he says.

The State Bank of Pakistan’s 2021 report highlighted the unsustainable rise in federal pension expenditure, noting a Compounded Annual Growth Rate (CAGR) of nearly 14% between 2012 and 2023, a trend that has since picked up.

Future Outlook

If Pakistan is to continue under the current set of pension mechanisms, the bill, as per the CAGR of the pension bill will close in on Rs 4 trillion by the end of 2035. While the details of any reforms addressed at the administrative level are yet to be shared by the government, the financial projection looks bleak. It becomes a point of introspection for financial policy makers in the finance division and the establishment division, for which they might have to set aside their personal retirement privileges. A difficult call has already been made yet more difficult steps have to be taken to save Pakistan from this fast approaching headwind.  

Potential solutions from global trends 

The past three decades show that there have been significant changes in pension schemes in most developed and emerging markets. As per international best practices, the Pakistan Government’s DB and unfunded pension arrangements are out of line. Non-contributory, or DB, schemes are reducing and many countries have switched to DC plans due to financial stress caused by large pension bills. 

The advantage of such a switch is that the financing burden can be spread across different periods in a more stable and predictable manner.  New accounting standards have helped Governments to better understand the underlying accrued liabilities and the long-term costs of their pension arrangements.  DC pension programs, therefore, are replacing DB plans. The DC system by its very nature ensures that the accrual of benefits are fully funded. Thus, employers are guaranteed that no unfunded liabilities would emerge. 

However, this could have an adverse impact on employees since the value of their accumulated pension assets are not defined, and because they depend on the investment performance of underlying pension funds.  Most importantly, DC schemes allow employees to play a role in the investment decisions. This allows individual risk/reward preferences as well as leaves room for other considerations like wanting to invest only in Islamic securities. The employee will essentially become masters of their own destiny with respect to investment decisions about their retirement benefits, and may fetch more satisfying returns (both financially and otherwise) than they could have under the guaranteed DB system. 

The DB system is easier and safer, but the DC system is not a burden and it also allows for more freedom. 

Shahnawaz Ali
Shahnawaz Ali
The author is a Business and Finance journalist at Profit and can be reached via email at [email protected] and via twitter @shahnawaz_ali1


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