Malawi: Recent pension tax reforms detrimental to pension funds and employees

When I first read the Pension Act, it was clear then that the legislature decided to promote defined contribution funds (DC fund) as the preferred type of fund in Malawi. To remind some of the readers, there are fundamentally two types of pension funds: DC funds and Defined Benefit Fund (DB fund).

A DB fund promises a fixed monthly benefit at retirement. The rules of a DB fund may state the promised benefit as an exact amount, such as K180,000 per month at retirement. Most DB funds calculate benefits through a formula involving the employees’ service and salary histories. DB funds are more advantageous to employees who spend many years working for a single employer, and most governments prefer DB funds.

One of the reasons for this phenomenon is that it manifests an employer’s yearning to retain employees, who have acquired valuable skills, by designing DB funds to provide generous benefits to such long-term serving employees than to employees following other career paths. It is probably for the same reason that the current Malawi government pension scheme is a DB fund.

Elderly: On pension

One important feature of a DB fund is that if the fund investment performs poorly, the employer remains liable to pay the promised benefits. In other words, while employees enjoy fixed benefits in DB funds, the future cost to the employer remains uncertain. Hence, it is in the employer’s interest for the fund to be effectively managed.

Conversely, DC funds do not promise fixed benefits at retirement. Instead, the employer and employee contribute fixed amounts to an account in the fund. In Malawi, contributions are prescribed, and theemployer is obligated to pay ten per cent of an employees’ salary and employee pays five per cent. Hence, it is fair to say that DC funds are always fully funded. Once received, contributions are invested in the market by the board of trustees of the fund and the employee ultimately receives the account balance, which is based on contributions made and investment gains or losses.

Accordingly, employees assume the hazard of investment volatility in DC funds. If the investment is bad, the amounts received at retirement will be diminished. If the investment is good, the employee’s benefits at retirement increase.

As mentioned above, the Act envisages and promotes DC fund because it defines the contributions by every employer and employee in section 12; it promotes transfer of benefits and the switching of membership of a fund in sections 14 and 44; prescribes the establishment of individual accounts in section 11; and provided(s) tax incentives to employers and employee in section 13. These and other provisions bear the most significance in a DC fund environment and promote their proliferation.

Let me comment on the issue of the pension tax reforms vis-à-vis DC funds. Many readers will recall that when the Act came into force in June 2011, section 13 was suspended from implementation to allow for a review of the tax system. This review was conducted during the financial year 2011/2012. In his 2012/2013 budget statement, Minister Dr Lipenga announced that section 13 of the Act would beamended to make reference to the Taxation Act, where a new structure for taxation of pensions would be introduced. While these reforms have not yet been passed into law, the Minister hinted that the reforms will be crafted in such a way that contributions by the employee will be net of taxes and contributions by the employer will be deductible up to fifteen percent of the employee annual salary. Further, earnings from pension investments will be taxed at a rate of fifteen per cent. He added that pension benefits that accrue to the pensioner will be exempted from taxes. Some of these policy statements are reflected in the Taxation Bill 22 of 2012.

Following the budget statement, commentators expressed concern that the proposed tax regime will see a decline in employee’s savings. According to an article in the Daily Times on 27 June 2012, Mr Kaferapanjira from the Chambers of Commerce, observed that prior to the Act pension taxes were calculated based on an employee’s gross salary. So under that system if an employee earned K10,000 per month, her five percent contribution to the pension fund would be K500. He observed that under the proposed system the employee would be taxed on the K10,000 first.

Kaferapanjira hypothesized that if the taxation rate were thirty percent, the employee would be left with seventy per cent. This means that the contribution on the K10,000 monthly salary would be based on K7000 after deducting the thirty percent taxes from the monthly salary. The employee’s five percent pension contribution would now be K350 per month. Had the old tax system been maintained, the employees’ pension contribution would have been K500.

The point advanced by Kaferapanjira is that since employees will now save less there will be fewer savings than would have been case had government maintained the old taxation model. On the other hand, the government will get more taxes now than if it decided to collect those taxes in the future. If Kaferapanjira is correct in his assertions then employees who belong to DC funds (which is over 90% of employees in Malawi) will be the most negatively affected since their benefits are dependent on how much they contribute to the fund. Those employees will be forced to save less every month due to the proposed tax regime. They would stand to benefit had the government chose to defer pension taxes until employees exit the fund, which is the approach most countries have adopted. In this way, employees belonging to both types of funds would have benefited, including those employees wishing to save more than the minimum required contributions. For employees belonging to DB funds, the proposed changes in the tax regime may not affect them as much given that their benefits are guaranteed by the employer.

There is another point to be made in relation to these proposed tax reforms. Since there is already a proliferation of DC funds in Malawi (as I have said at least over 90% of funds are DC funds), the likely effect of these tax proposals is that DC funds will not have as much money to invest into the economy since less money will be contributed by employees into the pension fund. Ultimately, this will affect theamounts of benefits that employees will receive at retirement.

The overall effect of this proposed tax reform is that it will remove the incentive to save and ability of pension funds to contribute to economic development through their investment. There is also likely to be a ripple effect of these reforms on the economy to the extent that employees will have less money in their hands to spend into the economy since employee pensions will be taxed now and not in the future. Therefore, it was important for the Act to provide a tax incentive by making all pension contributions tax deductible.

Frankly, I believe that section 13 as originally configured was the preferred tax approach without it the primary objectives of the Act are under threat. Section 13 of the Act reflected a clear desire by the legislature to promote a savings culture.

There is another reason I believe the Malawi Act promotes DC funds as opposed to DB funds. It introduces new, costly and stringent funding requirements to address inadequate funding issues associated with DB funds. Under these requirements in section 87, most DB funds must be fully funded within three years. Additionally, the Act requires employers operating DB funds to provide accurate actuarial fund assessments every two years, which is a costly exercise and will likely lead to the decline of DB funds.

Malawi is not the only country that has passed legislation promoting DC funds. It is a widely held view among academics that the US Pension Protection Act of 2006 robustly enhances DC funds to the extent that DB funds will likely disappear. Since the legislature has chosen to promote DC funds in Malawi, the question is whether this is good or bad? I will attempt to address this question next time.

 

Prof Mtende Mhango, is the deputy dean at the Wits University, School of Law. He is also the deputy chair of the Board of the Wits University Retirement Fund with an asset value of R1,8 billion.

 

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