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T-Day: Contribution Formula Strategies

| Regulatory Reform

By Yvette Harris, Principal Consultant, Simeka Consultants and Actuaries

Quarter 2: 2014

From T-day (01 March 2015), formulas in the Income Tax Act, in terms of which contributions are deducted, will be amended to be expressed as a percentage of “remuneration” and members will continue to enjoy tax relief relative to their remuneration. Currently, most funds formulate their contribution rates as a percentage of pensionable income (PEAR). Given the call by National Treasury for simplification and standardisation of retirement funds, trustees and employers will need to consider ways to align the calculations.

Know your terminology

  • Pensionable earnings (PEAR) is a percentage of annual salary or total guaranteed package (TGP).
  • TGP is sometimes referred to as Total Cost To Company –TCTC or Total Cost of Employment – TCoE; we will, for convenience, just refer to TGP.
  • Remuneration has a technical meaning in terms of the Income Tax Act. It will include all member income, including the monthly payment of their total guaranteed package (TGP). However, remuneration also reflects payments such as travel allowances and may, therefore, fluctuate relative to the travel claims submitted by individuals each month. This aspect makes the use of remuneration unpredictable.

Pensionable salary (PEAR) and annual salary
Many employers set PEAR at between 70% and 80% of TGP. Where members’ incomes fluctuate, PEAR is often based on an average remuneration or commissions over a period. In some cases it is an amount agreed to between the employer and the member from time to time.

By using PEAR to calculate contributions, a contribution of 27.5% of PEAR will only be equal to a contribution of 22% of TGP (remuneration) if PEAR is 80% of TGP.

The formula used to calculate death and disability benefits is also based on PEAR in very many instances even though the benefit is typically referred to as three times annual salary.

If an employer wishes to redefine PEAR employment documentation will need to be amended and the fund will have to communicate the new contribution formula to members, and reassure members that the contribution rate will be recalculated so that the rand amount of the contribution remains the same. The fund rules and regulations may have to be amended accordingly.

Projected Pension Ratio (PPR) Calculator
Funds and employers who do not have the appetite for such an adjustment and who intend on retaining their existing PEAR formula may consider using a PPR calculator as the method of clarifying fund contributions and benefits to members. Such a calculator can translate the contributions into a single language and project pensions on a more consistent basis.

A PPR calculator can be rolled out as part of a member guidance and support strategy. In terms of such a strategy new members would be required to run the PPR calculator so that they can see first-hand what their projected retirement fund outcomes are likely to be and what they can do to improve those outcomes.

This procedure gives new members a good understanding of their retirement fund as it shows them the leverage points and empowers them to take appropriate action. In many instances, this procedure is also useful in assisting existing members who do not understand the factors that influence their ultimate retirement benefit.

Once members have done the exercise they are much more prepared to own and take responsibility for their personal retirement plan.

PEAR equals TGP
A formula whereby PEAR equals TGP will be more closely aligned with “remuneration” and will best help members understand the contribution that they are making (and the risk benefit they will receive) in the context of their actual income. Many of the current formulas give members a false sense of comfort about the adequacy of the retirement provision they are making. A contribution of 7.5% of PEAR (that is 80% of TGP) is only 6% of TGP. Similarly, very few members understand that, based on this formula, their 75% income replacement disability benefit (when based on PEAR) will only amount to a benefit of 60% of their current income.

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