October 5, 2007

Social security schemes, pensions


Social Security may be defined as “social assistance and measures to address the needs of the poor and other vulnerable groups, irrespective of existing or previous employment status. This assistance is provided by the state/public institution.”{{more}} According to the ILO, “it also presumes that the members of society have already reached an acceptable standard of living. The goal of Social Security then may be referred to as “providing individuals and families with the assurance that their standard of living will not be totally eroded when they are faced with temporary or permanent loss of income” and “to bridge the gap between affluence and need.” The main ambition of social security is, therefore, to protect its members from a fall in their standard of living at retirement, rather than to help them achieve a higher level, and it may also be described as the “collective approaches a society has evolved to protect its members against economic risk” and measures to promote greater economic security. Social Security is intended to supplement the personal efforts of the individual to ensure access to certain basic goods and services critical for day to day to living. The primary purpose should be to provide a stable, predictable and adequate source of retirement income for all involved, but the systems are subject to a variety of risks.

The requirements for an adequate pension

A retired person usually obtains retirement income from Government Public Pensions, Social Security Old Age Pension or from personal savings, which the individual would have set aside for this purpose during his/her working life.

Irrespective of the source of income, the issue of adequacy becomes important. It, therefore, becomes necessary to define adequacy, because what is adequate for a low-income retired worker might be inadequate for a high-income retired worker.

One definition of adequate retirement wealth is to have enough resources to maintain pre-retirement living standards. A common rule of thumb, often used by financial planners, is that retirees should be able to accomplish this goal by replacing 60-80 percent of pre-retirement income.

Maintaining living standards, though, raises some important conceptual problems. For example, retired people have much more leisure time and so literally can substitute time (leisure) for money (consumption expenditure) in maintaining living standards.

Adequacy of pension also depends upon whether the retired person is able to meet the cost of living expenses year after year. For example, if a person’s pension at retirement is $150.00 per month, and that amount allowed him/her to purchase a certain amount of groceries and pay bills, but the following year the same amount is insufficient to buy the same amount of groceries and pay bills, then that amount is inadequate. To curtail this inadequacy, it becomes necessary to index pensions so that as cost of living increases, pensions will gradually increase. In other words, adequacy is determined by the purchasing power of the dollar (real value) and not by the nominal value.

The role of Private Pension Plans

Within recent years, persons have been becoming aware that it is necessary to invest monies in some type of private pension plan to augment retirement income that may come from social security, employer-sponsored pension plan or even personal savings at a bank or credit union.

There are many reasons for this decision. Some of the main ones include but are not necessarily limited to the following factors:

  • Social Security funds do not cover a person’s total salary during his/her working life. There is a ceiling (i.e.) No. Social Security contributions are required on higher earnings. This is so designed to allow room for high-income workers to establish occupational pension plans and to have private savings. In most cases, this ceiling is below the person’s gross income or below his net pay.

  • Social Security funds are not 100 percent replaceable. There is a maximum rate. In most instances, this is about 60 percent of average insurable earnings over a three years span. This necessitates proper retirement planning so that during retirement the worker will be in a position to take care of his needs in a similar way as it was done prior to retirement

  • Social security is guaranteed. Total reliance on social security as a form of pension will not adequately cover the needs of the retired person.

  • In most cases, Public Pension systems are calculated on a formula, but once the pension is calculated it is only adjusted periodically, whenever there is a general increase, so that it does not make allowance for inflation through indexation. This means that the public pension retirement dollar is constantly eroded by inflation. Purchasing power is reduced, and the worth of the public pension is dramatically reduced.

There are several options for private pension plans. Advanced Technology allow investors to do analyses on an annual basis to determine the best option that a person can choose (based on age and income) to allow for an adequate requirement income.

The role of private pensions plans, therefore, is to afford persons additional avenues for saving to ensure that their retirement income is both secure and adequate.

  • Contributed by the Eastern Caribbean Central Bank in support of Financial Literacy Month, October 2007 – “Save For Your Future”