The advent of the three-tier pension scheme saw the introduction of new industry players to the pensions sector, one that had been hitherto managed by the Social Security and National Insurance Trust (SSNIT). In essence, the three-tier scheme added two new schemes to the then existing SSNIT scheme- the compulsory (for formal sector workers) Tier 2 scheme and the voluntary Tier 3 scheme (for both formal and informal sector workers).
While the SSNIT scheme benefits are guaranteed, these two schemes introduce additional risk for potentially higher returns. Private scheme operators, licensed by the regulator of the pensions industry, the National Pensions Regulatory Authority (NPRA), manage these schemes. Contributors, through their employers or on their own, can choose which operators to manage their pension funds.
Reporting, responsiveness and accountability to pension contributors are, thereby, enhanced. Contributors, by taking a bit more risk, stand to potentially make the most out of their pension funds.
The three main operators of pension funds are:
- Trustees (corporate or in-house/member-nominated) to whom the management of the pension funds are primarily entrusted
- Custodians who hold all assets, and documentation covering the assets, of the fund
- Fund managers who are entrusted with the duty of investing the funds.
To be involved in the management of pension funds, an organization or individual has to be licensed or approved by the regulator to act as one of these. The requirements for licensing or approval differ for each class of operator. Since they hold the assets of the fund, for instance, custodians who are usually commercial banks, are required to show adequate liquidity and solvency. Trustees, on the other hand, require to show competence and expertise with systems, quite similar to fund managers.
The main pension benefits are superannuation and monthly payments till death. Both have their usefulness. An important consideration, however, is the financial ability of the pension fund manager to pay beneficiaries their due on time. When a pension fund is underfunded, it can lead to its collapse. The three-tier scheme takes part of the burden of paying pension beneficiaries from SSNIT. That way, more focus is brought to bear by each operator on their mandates for efficiency and effectiveness.
Which really is better: a superannuation (one-time lump-sum payment) with no monthly payments or monthly payments till death? Get this. One may not be necessarily better than the other because it depends on individual preferences and circumstances. If there are opportunities for good investments, like a business venture, that would make a lump-sum payment beneficial.
The payment could then be used as capital in the business venture. The lump-sum, therefore, affords more flexibility and control by the beneficiary. However, that would also mean more responsibility on a pensioner for managing the business and its proceeds. On the other hand, monthly payments, though comparatively smaller and quite restrictive, are ideal for passive beneficiaries who are content with the smaller amount and have less risk to bother about.
The Three Tiers
The three-tier pension scheme is an amalgamation of both worlds. The Tier 1 scheme, managed by SSNIT, provides for monthly payments to qualifying beneficiaries. Every month, a pensioner would, therefore, have available to meet expenses, an assured amount of money. This predictability is very important. The pensioner would, at least, be able to plan what expenses would be taken up by these monthly payments. For instance, certain parts of expenses associated with regular visits to the hospital for the management of chronic ailments can be borne by SSNIT monthly pension payments.
The Tiers 2 and 3 pay out lump-sums, solely, to qualifying beneficiaries. Tier 2 is compulsory for all regularly employed workers and it is a defined contribution pension scheme. It is totally tax-free. Upon retirement, a lump-sum consisting of contributions plus investment gains are paid out to the pensioner. The contributions come from monthly deductions (5% of the employee’s basic salary). The pension funds are privately managed.
Tier 3, on the other hand, is voluntary. Workers in the formal sector can be involved through a workplace compensation scheme which is not statutory, like a workplace provident fund to which all workers in the organization are signed on. Contributions are usually done by both the employee (a deduction from salary) and the employer on the behalf of the employee. A tier 3 scheme is also a defined contribution scheme, like tier 2 schemes. Beneficiaries therefore receive a lump-sum payment on retirement.
Act 766 & Tax Benefit
From Section 112 subsection 20 of the Pensions Act, Act 766, “Contributions not exceeding sixteen and one half per centum of a contributor’s monthly income, made by either a contributor or the contributor’s employer or both shall, be treated as deductible income, for the purpose of income tax for the contributor and the contributor’s employer to the extent of their respective contributions.”
Therefore, formal sector workers can contribute up to 16.5% of their basic salaries tax-free towards a Tier 3 scheme. Informal sector workers can contribute up to 35.0% of their income tax-free to a pension scheme. Anything in excess of the stipulated 16.5% and 35% for formal and informal contributor respectively attracts income tax.
The tax-free nature of contributions to all tiers of the pension scheme is an important consideration and incentive. It ensures that contributors can make more when they contribute. There is a significant disincentive for withdrawing from the Tier 3 scheme prior to ten years (for formal sector employees) of contribution and five years of contribution (for informal sector workers). Withdrawing amount would be paid net of all tax-waivers to contributions associated with the withdrawal. For instance, a formal sector contributor has paid into a Tier 3 scheme for seven years and has accumulated GHS 10,000.
The contributor needs to make a withdrawal of GHS 5,000. All taxes waived for 50% of contributions made shall be calculated and deducted from the GHS 5,000. Suppose the taxes waived amounts to GHS 800. The contributor would therefore have access to GHS 4,200 out of the GHS 5,000, with the GHS 800 paid to the Ghana Revenue Authority as income tax. This GHS 800 would, however, have been retained if the withdrawal had been made after ten years of contribution (one hundred and twenty months).
For this reason, contributors stand to benefit from more tax waivers by increasing contributions up to the maximum allowable amount of 16.5% (for formal sector employees) or 35% (for workers in the informal sector).
There is one very important and helpful point about withdrawals made from Tiers 2 and 3 schemes. Our Tiers 2 and 3 pensions can be used as down payments to acquire mortgages for home purchases. A mortgage is a legal agreement by which a lender, usually a bank, a building society or other financial institution, agrees to lend money at interest in exchange for taking title of the debtor’s property, with the condition that the borrower would make payments to the lender until all payments are completely.
At this point, the title moves from the lending bank to the borrower. Usually, a mortgage lender would require the borrower to put up an amount, referred to as down payment, representing a percentage of the value of the property. This reduces the risk of lending the mortgage. The rest of the cost of the property would then be paid by the lender so that the borrow can take possession (but not the title) of the property. As pension contributors seeking to acquire our first home, we can use the accumulated amounts in our tiers 2 and 3 funds towards the down payment the lender requires.
Obviously, the three-tier pension scheme provides much more for pension fund contributors. The Tier 3 scheme, with its tax waivers and which makes provision for workers in the informal sector to have pension funds to look forward to receiving at the end of their work lives. The introduction of some risk for potentially higher investment returns for pension funds is another feature the three-tier scheme has introduced, along with the participation of new private licensed operators.
The superannuation provided by both Tiers 2 and 3 with enhanced investment return potential and the monthly payments provided by SSNIT are very valuable. We can now ask ourselves at this point: do we contribute to any pension scheme? It is time to quickly do so if we don’t. Speak to a licensed pension fund trustee or your investment advisor today and get enrolled in a scheme.
About the Author
Through his writings Kwadwo has discovered his love and knack to simplify complex theories spicing them with everyday life experiences for the benefit of all.
The Head of OctaneDC Research, Kwadwo Acheampong, has over a decade experience in fund management and administration, portfolio management, management consulting, operations management and process improvement.
Feel free to send him your feedback on his article. Email: [email protected]