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 you 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.
The SmartRupee plan helps you figure out how to think about this option, and how it can fit into your broader financial planning. 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.
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.
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. The SmartRupee app asks you to define the maximum employer contribution amount in rupees so as to avoid confusion.
Here is the benefit to the employee: 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.
So far, the provident fund sounds great. 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. SmartRupee recommends 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.
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.
ONE KEY DRAWBACK OF A VPS is that there are strict conditions for withdrawal before the age of 60, compared to the provident fund, where there are no restrictions. In SmartRupee’s view, however, this is a benefit because it helps enforce investing discipline, and reinforces our guideline that savings for short-term needs or emergencies should not be mixed with longer-term investing for retirement and other needs.
Nonetheless, anyone seeking to invest in a VPS should be aware of these restrictions before signing on to them.
SmartRupee is working with employers to persuade them to switch over from the provident funds to the VPS, so as to allow their employees better, more customised options recommended by our analysts. If you believe your employer might be open to such a move, please do contact us.