Why Voluntary Pension Schemes are better than Provident or Gratuity funds

If you are employed at a company in Pakistan – and even if you are a younger employee at a government institution – there is a very good chance that your employer offers a provident fund or a gratuity fund, and possibly both. When creating your financial plan, the savings offered in your company’s provident or gratuity fund can be a considerable option and well worth consideration.

But first, some context.

A provident fund is a benefit granted by employers to their employees and is explicitly meant to facilitate retirement savings. Here is how it works: an employee can contribute a certain percentage of their salary every month to the fund, and the employer pledges to match their contribution up to a certain percentage.

For example, a company might say that they will match up to 10% of the basic salary (which is usually lower than the total salary) of provident fund savings by every employee. So, for instance, if an employee’s basic salary is Rs30,000 out of a total salary of Rs50,000, the employer will contribute up to Rs3,000 per month towards the employee’s provident fund (that is, 10% of the Rs30,000 not the Rs50,000).

Here is the catch, however: the employee also needs to contribute Rs3,000 per month in order to receive that matching. If the employee contributes only Rs2,000 the employer will also only contribute Rs2,000. However, if the employee decides to contribute more than the employer maximum – say, Rs3,500 – the employer will still only contribute the maximum of Rs3,000 per month.

It is this reason that a lot of employees often tend to not contribute to their provident funds: because it feels like one is reducing one’s take-home pay. In reality, however, the employer’s contribution is essentially ‘free money’ that serves as a 100% immediate return on investment.

In the example above, the employee is only saving Rs3,000 per month, but Rs6,000 per month are going into their account every month. That employer contribution – if available to you – should be maximised. If you do not, you are essentially forgoing money that you are entitled to. Any returns you earn on those doubled assets would be over and above that effective 100% return.

Why would you give that up? What could you possibly do with your money that would match that rate of return? Our advice: always maximise the contributions into your provident fund at least up to the full employer matching contribution. If you do not, you are leaving free money on the table that your employer has set aside as part of the benefits they owe you.

These amounts, of course, change as the employee’s salary changes. Some companies define the benefit as a percentage of basic salary, and others define it as a percentage of gross salary. It is important for you to understand exactly what your own employer’s policy is so that you can determine how to maximise the savings that you put in place for yourself.

So far, the provident fund sounds great. It is a way to automatically ensure long-term savings, and is much better suited to one’s needs than the ‘committee’ method that many families use to save.

There is, however, a problem with the structure of provident funds both legally, as well as how they are structured in practice in Pakistan.

In theory, each employee has their own provident fund which can be managed separately according to the needs of the employee. In practice, however, companies tend to lump all employees’ money into one fund and then make investment decisions for that investment fund. That might not sound like a bad idea, but it is.

Think about it: every employee has different financial needs, and therefore needs to invest their retirement funds in the provident fund differently. A young 25-year-old employee has a long career ahead of them, and plenty of time before retirement, which means they can afford to take risks.

At Elphinstone, for most of our clients, we would recommend that such a person should be 100% invested in a diversified portfolio of stocks. By contrast, a 55-year-old manager is getting closer to retirement and should probably be invested much more heavily in government bonds.

In deciding how to invest, whose needs do you think the company’s management takes into account? The 55-year-old manager, of course. It is the most conservative, low-risk option.

Companies will – by definition – take the most conservative path because the law makes them liable for any losses if they do not adhere to the rules laid out for investments in provident funds. Since employees have no control over their investing decisions for their provident funds, companies are liable for any losses, and employees have the right to sue their companies if they face losses on the investments in their provident fund.

As a result, companies try to minimise their liability and invest in only the most conservative investments possible, such as government bonds. This works fine for older employees, especially those age 55 and above, but for anybody who is younger, it is a bad deal.

Even if a particular company decided to allow investments in individualised accounts for provident funds, they would still encounter rules that prevent them from creating portfolios that may be appropriate for the needs of each employee. Moreover, the employee themselves has very little say – if any at all – in how the money can be invested.

So, while the provident fund is great in terms of giving employees access to additional money for retirement savings, it is not good from the perspective of being able to create customised investment portfolios that suit the needs of each individual employee.

However, Pakistani law does offer a better alternative: the Voluntary Pension Scheme (VPS).

If a company switches from a provident fund to a VPS, employees would get access to pension funds managed by asset management companies and be allowed to choose which asset allocation better suits their needs, while retaining access to the employer contributions towards retirement benefits that they currently have access to in the provident funds.

In other words, the VPS allows employees to have the best of both worlds.

And in the 2020 budget bill, the government withdrew one of the biggest drawbacks of investing in a VPS.

Previously, it used to be that there were strict conditions for withdrawal before the age of 60, compared to the provident fund, where there are no restrictions. Employees can withdraw their at least 50% of their money tax-free after the age of 60 or after 25 years from their first investment in a VPS, whichever comes first. In theory, if you start saving at 22, you could withdraw the bulk of your money tax-free by age 47. The other half would be taxable at normal tax rates.

Provident fund withdrawals – if not immediately reinvested into another provident fund – are 100% taxable, which means that in theory, a VPS is a much better product from a taxation perspective than a provident fund.

However, in practice, as we all know, hardly anyone voluntarily pays taxes in Pakistan unless it is deducted at source. The law allowed for provident funds to be withdrawn without income tax deduction, but not funds from a VPS, which meant that – in practice – it felt like provident funds are untaxed and VPS schemes are taxed.

In the 2020 budget bill, however, the government introduced parity, allowing for withdrawals from VPS that are similar to those of the provident fund: no tax is required to be withheld by the asset management company anymore. You would still owe taxes on early withdrawals on both provident funds and VPS – and we strongly advise you to pay those taxes as soon as possible – but they are no longer automatically withheld on either option.

That means that there is now absolutely no advantage that provident funds have over Voluntary Pension Schemes, and every single employee of every single company should ask their employers to switch from a provident fund to a VPS. And even if your employer does not offer that plan, you can enroll in a VPS yourself.

 Interested in learning more about how to enroll in a VPS? Or have another question about personal finance? E-mail your questions to [email protected]. Your identifying information will be kept completely confidential.