Why Voluntary Pension Schemes are better than Provident or Gratuity funds

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If you are employed at a company in Pakistan – and even if you are a younger employee at a governmentinstitution – there is a very good chance that you employer offers a provident fund or a gratuity fund, andpossibly both. When creating your financial plan, the savings offered in your company’s provident orgratuity 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 yourbroader financial planning. But first, some context.A provident fund is a benefit granted by employers to their employees and is explicitly meant to facilitateretirement savings. Here is how it works: an employee can contribute a certain percentage of their salaryevery 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 usuallylower than the total salary) of provident fund savings by every employee. So, for instance, if anemployee’s basic salary is Rs30,000 out of a total salary of Rs50,000, the employer will contribute up toRs3,000 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 receivethat 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 – theemployer 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 thebenefit as a percentage of basic salary, and others define it as a percentage of gross salary. TheSmartRupee app asks you to define the maximum employer contribution amount in rupees so as to avoidconfusion.Here is the benefit to the employee: the employer’s contribution is essentially ‘free money’ that serves asa 100% immediate return on investment. In the example above, the employee is only saving Rs3,000 permonth, but Rs6,000 per month are going into their account every month. That employer contribution – ifavailable to you – should be maximised. If you do not, you are essentially forgoing money that you areentitled to.So far, the provident fund sounds great. There is, however, a problem with the structure of providentfunds 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 tothe needs of the employee. In practice, however, companies tend to lump all employees’ money into onefund 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 theirretirement funds in the provident fund differently. A young 25-year-old employee has a long career aheadof them, and plenty of time before retirement, which means they can afford to take risks. SmartRupeerecommends 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 heavilyin government bonds.In deciding how to invest, whose needs do you think the company’s management takes into account? The55-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 theneeds of each employee. Moreover, the employee themselves has very little say – if any at all – in howthe money can be invested.So, while the provident fund is great in terms of giving employees access to additional money forretirement savings, it is not good from the perspective of being able to create customised investmentportfolios 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 fundsmanaged by asset management companies and be allowed to choose which asset allocation better suitstheir needs, while retaining access to the employer contributions towards retirement benefits that theycurrently 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 abenefit 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 otherneeds.Nonetheless, anyone seeking to invest in a VPS should be aware of these restrictions before signing onto them.SmartRupee is working with employers to persuade them to switch over from the provident funds to theVPS, so as to allow their employees better, more customised options recommended by our analysts. Ifyou believe your employer might be open to such a move, please do contact us.ARTICLE 7How to think about emergencies and short-term cash needs in your financial planningAt SmartRupee, we look like we are all about long-term planning and savings. We most certainly doemphasise that part of financial planning, but we also acknowledge the undeniable reality: most peoplehave short-term savings needs as well, and nearly everyone needs to have at least some cash saved upfor emergencies as well.The SmartRupee model allows this possibility and captures it in our short-term cash savings model, whichwe assume every single one of our clients will need. In our short-term cash savings model, we capturetwo distinct categories: cash you may need for emergencies (things happen, and you would ideally nothave to borrow money for situations where you need something extra), and any short-term needs youmay have. The short-term needs can include things like saving up for a car or motorcycle, going on avacation, etc.Ideally, of course, one would want this to be a number as large as possible to feel completely safe, butone needs to be realistic. At SmartRupee, however, we have determined that the benchmark peopleshould have at all times is three times their monthly salary: if you have that much, you should feel like youcan handle short-term cash needs or most emergencies.Of course, sometimes life can throw even bigger surprises at you, and nobody can be 100% prepared foreverything. But this much will help you be prepared for many things that may come your way, and we willhelp you save a little each month until you hit this point.Our model assumes that you need to save up for up to three months’ salary in short-term cash needs,and then allows you up to three years to save up in order to get there. Since these are short-term needsthat you may need at any given moment in time, we only rely on conservative investments in the form ofhigh-quality fixed income funds with a demonstrated track record.Once you reach the 3-months’ savings goal, our model will then modify your savings needs downwards toreflect any increases in your salary that may have taken place over those three years.

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