Would my pension be adequate for me? This is one forgettable and yet important question we all need to ask when planning for our retirement. It is a question we do not ask most often because retirement may be a bit of years away but it is important to know if we are ever planning retirement. It is possible to have an idea especially for the formal sector workers whose income is regular. Retirement benefit would usually be a fraction of the income earned before retiring. The retirement income expressed as a percentage of pre-retirement income is called income replacement ratio. A simple illustration is if one earned Gh2,500 per month prior to retirement and now earns Ghs1,500, the replacement ratio is 60%. It is a measure of the adequacy of retirement income. The global replacement ratio is estimated as 68% but could be lower or higher for any individual based on the arrangements in place.
In Ghana, the introduction of the the 3-tier scheme could replace any part of the income from 50% to 100% depending on how contributions were planned. Each tier replaces a portion of preretirement income to make up the total replacement amount.
One objective of planning for retirement is to boost this income replacement ratio. Though retirement income adequacy is dependent on one’s lifestyle it would be worthwhile for an individual to aim at getting a higher replacement rate during retirement.
The full dynamics of the replacement income ratio has a lot of aspects that cannot be discussed in this piece, however there is a common mistake worth pointing out concerning planning for retirement.
The basis of determining retirement contributions and therefore benefits is based on gross taxable income. However, in some institutions, there are components of salary that are untaxed allowances. The untaxed allowances, which add to the total income the individual enjoys now, does not form part of contributions. In such a situation the individual would be paying less contribution than what should really have been paid based on their total income. The attendant effect is that they would receive benefits much less than the expected replacement ratio because there was a portion of the income (i.e. the untaxed allowances) that did not count towards the level of contributions for both the mandatory 1st and 2nd tiers and the voluntary 3rd tier. It would therefore be flawed for one to assume an expected retirement income (or replacement ratio) based on a total income which has untaxed portion not taken into account.
Possibly we would be eating away a portion of the replacement potential as we continue to draw higher preretirement incomes today but pay lower contributions on them.
The danger is that one would have built a lifestyle based on the current incomes while retirement incomes would be much lower. The above scenario is mostly preferred by individuals who usually argue that they are may be sponsoring dependants which is financially demanding, and so are happy to utilise those allowances upfront. Expenses like school fees, building a house and raising the family is at its peak and this is where they need money for the family expenditure. This is realistically understandable as a personal financial planning decision. It is only important that we are fully aware of this shortfall risk staring in our faces, and that this shortfall would affect the potential benefits in future.
There is however a way to indirectly slice off those un-taxed allowances into a pension scheme. The law allows a tax-free limit of up to 16.5% of gross salary to be paid into the 3rd tier scheme. If your company is doing the 3rd tier, but there is some unused tax free allowance of the 16.5% for your contribution, try to slice a lot more from your mainstream taxable salary into the fund. For example if contributions into the 3rd tier is 10% of your gross salary, you can decide to top up 6.5% of your taxable salary. The non-taxed allowance can add up to the available usable income. Indirectly you would be saving some part of the non-taxed allowance.
If your company is not doing the 3rd tier, look for a pension trustee and contribute some amount of the taxable gross salary into their 3rd tier personal scheme.
However, if your company is doing the 3rd tier and has fully utilised the 16.5% tax-free allowance, a good option is to look for a long term and less accessible instrument to directly invest a portion of the untaxed allowance. You may not benefit fully from the tax advantages of the pension fund, but at least the investment money was part of untaxed allowances so there is some advantage there. It is strongly recommended that you seek further advice if you are not routinely involved in investments.
For the informal sector individuals to determine their adequacy, they should be able to identify their financial needs and be able to look after their business to keep yielding fruits in the old age of the business owner. The investment advice for the formal sector person also goes for the informal sector.
It is of utmost importance that one has an idea of their financial needs during retirement and work towards getting an income replacement ratio of at least 85%. Going for a higher replacement ratio is possible in spite of the expenses facing every active working individual or a family. This article has looked at retirement earnings based mainly on pension contribution within the Ghanaian pension framework. Other viable options have been discussed in other editions.
It is actually possible to earn more in retirement than at the working stage by investing in other businesses and managing risks appropriately. And what a time of retirement it would be if it so happens!
Author: YAW KORANKYE ANTWI- The author is a Pensions Expert and a Certified Risk Management Professional.