Studies
Studies 

WHY NOT PRE-NEED PLANS FOR CORPORATE RETIREMENT PROGRAMS?

 

 

 

Background

 

Republic Act 7641 (R.A. 7641) mandates payment of minimum retirement benefit of one-half month salary (equal to fifteen (15) days plus one-twelfth (1/12) of the 13th month pay and the cash equivalent of not more than five (5) days of service incentive leaves) per year of service for an employee who retires at least 60 years of age with at least five (5) years of continuous service. In the rules published by the Department of Labor and Employment, monthly salary was clarified as final monthly salary.

 

Most retirement programs in the country, most probably influenced by R.A. 7641, provide a benefit which is a multiple of final monthly salary per year of service e.g. one (1) final monthly salary per year of service.

 

Other than the normal retirement benefit, most retirement programs also provide early retirement, vesting, death and disability benefit. These benefits are usually percentages of the normal retirement benefit or multiple of final monthly salary per year of service e.g. 5-year vesting of 25% of final monthly salary per year of service.

 

Below is a sample retirement program:

 

1.      Normal Retirement Benefit: One Hundred Fifty Percent (150%) of Plan Salary per year of service

Eligibility: Age 60 and 5 years of service

 

2.      Late Retirement Benefit: Same as the Normal Retirement Benefit

Eligibility: Beyond Age 60 but not more than Age 65 subject to the consent of the Company

 

3.      Early Retirement Benefit: Same as the Normal Retirement Benefit

Eligibility: Age 50 with at least 10 years of service

 

4.      Death / Disability / Other Involuntary Separation Benefit: Same as Normal Retirement Benefit

 

5.      Vesting Benefit: Percentage of the Normal Retirement Benefit per year of service, in accordance with the following table:

Years of Service

Percentage

Less than 5 years

NIL

5 years

25%

10 years

50%

15 years

75%

20 years

100%

 

Most retirement programs are funded through the medium of a fund held by a Trustee. Contributions to the retirement fund plus earnings constitute the retirement fund. Benefits are paid out of the retirement fund.

 


Why Not Pre-Need Plans?

 

1.   Pre-need plans could not provide the exact benefits as a multiple / percentage of final monthly salary per year of service.

 

Pre-need companies determine the amount of maturity value by assuming a uniform salary increase rate upon issue. Actual salary increases, however, do not exactly follow the assumed rate. The maturity value therefore would either be less or higher than the actual retirement benefit.

 

Termination values are factors of the contributions / installments paid and in no way it can fit into early retirement or vesting benefits as a percentage of salary per year of service.

 

The death benefit under a pre-need plan, if any, is usually equal to the pre-need price or the maturity value and thus, would not fit into a retirement program death benefit which is a percentage of salary per year of service.

 

Finally, the disability benefit under a pre-need plan is usually waiver of premium only and therefore could not provide a retirement program disability benefit which is a percentage of salary per year of service.

 

Below are samples illustrating the separation (vesting / retirement) benefit and death benefits based on the sample retirement program above and on a sample pre-need plan. The variances are also shown.

 

Illustration 1: Employee A

Current age            : 45

Hire age                 : 36

Current Salary        : P 20,000

Salary Increase      : 5% p.a.         

 

YOS

Age

Salary

Separation Benefit

Death Benefit

Pre-need Plan

Variances

Paymt

Term Value

Insurance

Separation

Death

10

46

20,000

 200,000

200,000

70,000

    -  

 700,000

   200,000

(500,000)

11

47

21,000

231,000

231,000

70,000

14,000

 700,000

   217,000

(469,000)

12

48

22,050

264,600

264,600

70,000

 21,000

 700,000

   243,600

(435,400)

13

49

23,153

300,983

300,983

70,000

56,000

 700,000

   244,983

(399,018)

14

50

24,310

340,342

340,342

70,000

70,000

 700,000

   270,342

(359,658)

15

51

25,526

382,884

382,884

70,000

126,000

 700,000

   256,884

(317,116)

16

52

26,802

428,831

428,831

70,000

147,000

 700,000

   281,831

(271,169)

17

53

28,142

478,414

478,414

70,000

224,000

 700,000

   254,414

(221,586)

18

54

29,549

531,884

531,884

70,000

252,000

 700,000

   279,884

(168,116)

19

55

31,027

589,505

589,505

70,000

350,000

 700,000

   239,505

(110,495)

20

56

32,578

651,558

651,558

    -  

512,304

 700,000

   139,254

  (48,442)

21

57

34,207

718,343

718,343

    -  

599,396

 700,000

   118,947

     18,343

22

58

35,917

790,177

790,177

    -  

701,293

 700,000

     88,884

    90,177

23

59

37,713

867,399

867,399

    -  

820,513

 700,000

     46,886

  167,399

24

60

39,599

950,367

950,367

    -  

960,000

 700,000

 (9,633)

  250,367

 

Illustration 2:  Employee B

Current age            : 45

Hire age                 : 45

Current Salary        : P 30,000

Salary Increase      : 5% p.a.         

 

 

YOS

Age

Salary

Separation Benefit

Death Benefit

Pre-need Plan

Variances

Paymt

Term Value

Insurance

Separation

Death

1

46

30,000

 -

 30,000

 65,000

 -

 650,000

 -

(620,000)

2

47

31,500

 -

 63,000

 65,000

 13,000

 650,000

 (13,000)

(587,000)

3

48

33,075

 -

 99,225

 65,000

 19,500

 650,000

 (19,500)

(550,775)

4

49

34,729

 -

138,915

 65,000

 52,000

 650,000

 (52,000)

(511,085)

5

50

36,465

 45,581

182,326

 65,000

 65,000

 650,000

 (19,419)

(467,674)

6

51

38,288

 57,433

229,731

 65,000

117,000

 650,000

 (59,567)

(420,269)

7

52

40,203

 70,355

281,420

 65,000

136,500

 650,000

 (66,145)

(368,580)

8

53

42,213

 84,426

337,704

 65,000

208,000

 650,000

 (123,574)

(312,296)

9

54

44,324

 99,728

398,913

 65,000

234,000

 650,000

 (134,272)

(251,087)

10

55

46,540

 465,398

465,398

 65,000

325,000

 650,000

 140,398

(184,602)

11

56

48,867

 537,535

537,535

 -

475,482

 650,000

 62,053

(112,465)

12

57

51,310

 615,722

615,722

 -

556,314

 650,000

 59,408

 (34,278)

13

58

53,876

 700,384

700,384

 -

650,888

 650,000

 49,496

 50,384

14

59

56,569

 791,973

791,973

 -

761,538

 650,000

 30,434

 141,973

15

60

59,398

 890,969

890,969

 -

891,000

 650,000

 (31)

 240,969

 

2.   Ancillary benefits could not be made uniform or rational.

 

If we do away with the traditional practice of fixing the pre-normal retirement benefits as a percentage of salary per year of service, and instead using the pre-need plan termination value and the insurance component for pre-normal retirement benefits, benefits could not be made uniform, much less, rationale.

 

In the illustration above, after 5 years of service, Employee B has a termination value of P 65,000 whereas Employee A will only have a termination value after 11 years of service at P 14,000.

 

3.   Investment losses for early termination. Lower return even if held to maturity.

 

If a pre-need plan is terminated prior to maturity (due to pre-retirement separations), the termination value is so much less than the contribution paid. A sample Termination Value schedule is as follows:

Contribution Paid

Termination Value

20% of Pre-Need Price

10% of Contributions Paid

40% of Pre-Need Price

20% of Contributions Paid

60% of Pre-Need Price

30% of Contributions Paid

80% of Pre-Need Price

40% of Contributions Paid

100% of Pre-Need Price

50% of Contributions Paid

 

Funds under trust, if invested prudently, will have no such losses other than losses due to market fluctuation (and there could be potential gains too).

 

It should be noted that employee separations are not within the control of the plan sponsor.

 

Pre-need plans are transferable but transferring one plan from a separated employee to a new one is cumbersome and will usually not fit into the new employees' retirement needs and may further skew the other benefits.

 

Even if the plan is held to maturity, still, the effective rate of return is low because of the administrative expenses, taxes, agency compensation, etc.

 

4.   No funding flexibility.

 

Pre-need plan contributions are fixed and payable for a certain number of years. The pre-need plan lapses if contributions are not paid when due, thus, losses on the part of the retirement program sponsor.

 

It can be re-instated by paying the outstanding contributions but usually with penalty or high interest charges.

 

It does not have the funding flexibility that trust funds offer. Funding flexibility is important to avoid borrowing costs (cost of borrowing is usually higher than the earnings of the fund), to maximize tax incentives (funding during times when taxable income is positive would help reduce taxes) and to avoid losses in circumstances when there are no sufficient cash to contribute/pay to the program.

 

In addition, basically, one pre-need plan is purchased for one employee. In case the termination or maturity value of the pre-need plan purchased for an employee is not enough to pay for his retirement benefit, the retirement plan sponsor will be forced to shell out additional cash.  Funds under trust are unallocated and thus, funds "supposedly" allocated to other employees can be used to pay for the benefit of a retiring employee, if it need be.

 

5.  Undesirable impact on Expense/Income/Disclosure under the prevailing Accounting Standards.

 

Under prevailing accounting standards (PAS 19 or PFRS for SMEs), movement of the retirement plan asset is disclosed. For example, if at the beginning of the year, there is no plan asset and P 1.00M is contributed to the Retirement Fund under Trust and it earns 5% or P 0.05M, the disclosure would look like this:

 

      Contribution                            : P 1.00M

      Actual Earnings (Loss)             : P 0.05M

      Plan Asset (End of Year)           : P 1.05M

 

If the P 1.00M is used instead to buy, let say, a 5-years-to-pay pre-need plan, its termination value at the end of one year is usually just around 5% of what was paid or P 0.05M. The disclosure would then look like this:

 

      Contribution                             : P  1.00M

      Actual Earnings (Loss)              : P (0.95M)

      Plan Asset (End of Year)           : P  0.05M

 

In addition, losses are immediately recognized.

 

6.  There are tax-qualification issues

 

While there are pre-need plans qualified by the BIR, there are lingering issues whether it should really given tax-qualification or not. Because benefits could not be set uniformly (or by applying a uniform formula), other than probably the normal retirement benefit, the program could be deemed as discriminatory, and therefore, not tax-qualifiable.

 

Even if tax-qualified, the tax incentive on earnings (tax-free) could not be enjoyed.