Social Security in Ghana

MPSM609

Lecture 2

By Stephen A. Yeboah

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Definition of a Pension
One type of social benefit is the replacement of income lost from retirement or other inability to work. This replacement
of income is often referred to as a pension.
Typically, a pension is a regular payment made by an employer or the government, to provide retirees with income.

Pension plan
A pension (or retirement income) plan (arrangement or scheme) is a legally binding contract having an explicit
retirement objective. This contract may be part of a broader employment contract set forth in the plan rules or
documents, or may be required by law. The elements of the pension plan may be mandated by law or statute. In
addition to having an explicit retirement objective, pension plans may offer additional benefits, such as disability,
sickness, and survivors' benefits.

A pension plan is a programme offered by government/state or employers that provides a salary replacement when an
employee is no longer working (for example, when the employee retires).

A pension is a fund into which a sum of money is added during an employee's employment years and from which
payments are drawn to support the person's retirement from work in the form of periodic payments.

The common use of the term pension is to describe the payments a person receives upon retirement, usually under
pre-determined legal or contractual terms. A recipient of a retirement pension is known as a pensioner or retiree.
Pension benefits may be received from social assistance pension schemes, social insurance pension schemes or
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Definition of a Pension
 Replacing income suggests regular payments of an amount specified by some formula. Thus, a
pension is a fixed sum paid regularly to a worker following retirement from service or to surviving
beneficiaries. The sum is fixed in the sense that it is contractually determined. The monetary amount
can change if specified events happen, such as a change in the general price level. In some cases it
may also be possible for the person with a claim to the regular pension payments to exchange that
claim, or part of it, for a lump-sum payment.

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Types of Pension Schemes/Plans

There are two basic types of pension schemes:

I. Public Pensions
II. Private Pensions

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Public vs Private Pension Plan

Types of Pension Schemes
I. Public Pension Plan
Involves social security and similar schemes where the general government (that is central, state, and local
governments, including social security institutions) administers the payment of pension benefits. Their purpose is
to provide minimum (flat or/and earnings-related) benefits on retirement for the population at large (or at least the
formal sector). Public plans have been traditionally PAYG-financed,

II. Private Pension Plan

 Private pension is a pension plan where an institution other than general government administers the payment
of pension benefits.
 Private pension is a broad definition which covers both workplace pensions (occupational schemes)
arranged by employers and personal pensions set up by individual employees, including the self-employed.
 Private pension schemes are managed by the employer acting as the plan sponsor, a pension entity or a
private sector provider.
 Private pension plans may be complements or substitutes to social security systems. In some countries, these
may include plans for public sector workers. Private pension plans are funded.

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Types of Private Pensions Occupational vs Personal Pension Plans

I. Occupational pension scheme:

An arrangement organized by an employer or on behalf of group of employers or sometimes in conjunction with
labour associations (e.g. trade unions) to provide benefits for employees on their retirement and for their
dependants on their death. Generally, the plan sponsor is responsible for making contributions to occupational
pension schemes/plans, but employees may be also required to contribute.

Mandatory occupational plans:

Participation in these plans is mandatory for employers. By law, nationwide or industry-wide bargaining agreements, employers are
obliged to participate in a pension plan. Employers must set up (and make contributions to) occupational pension plans which
employees will normally be required to join. Where employers are obliged to offer an occupational pension plan (e.g. industry-wide
collective agreements with trade unions), but the employees’ membership is on a voluntary basis, these plans are also considered
mandatory.

Voluntary occupational plans:

The establishment of these plans is voluntary for employers (including those in which there is automatic enrolment as part of an
employment contract or where the law requires employees to join plans set up on a voluntary basis by their employers). In some
countries, employers can on a voluntary basis establish occupational plans that provide benefits that replace at least partly those of
the social security system (e.g. Employee Pension Funds in Japan, contracted-out schemes in the United Kingdom). These plans
are classified as voluntary, even though employers must continue sponsoring these plans in order to be exempted (at least partly)
from social security contributions.

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Types of Private Pensions Occupational vs Personal Pension Plans

II. Personal Pension Plans

An arrangement where the contract to provide contributions in return for retirement benefits is between an
individual and an insurance company. Such plans may be taken out by individuals on their own initiative – for
example, to provide a primary source of retirement income for the self-employed, or to provide a secondary
income to employees who are members of occupational scheme.

Mandatory personal plans

These are personal plans that individuals must join or which are eligible to receive mandatory pension
contributions. Individuals may be required to make pension contributions to a pension plan of their choice -
normally within a certain range of choices or to a specific pension plan.

Voluntary personal plans:

Participation in these plans is voluntary for individuals. By law individuals are not obliged to participate in a
pension plan. They are not required to make pension contributions to a pension plan. In some countries
personal plans become mandatory when they provide benefits that replace those of the social security system
(e.g. United Kingdom).

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Structure of Pension Systems

The structure of pension systems varies by two key dimensions:
 The way in which benefits are determined and;
 The way in which benefits are financed.

A. The determination of benefits follows one of two main methods:

(1) The defined benefit approach (DB), in which benefits are based on a formula that relies on how much
workers make and how long they work; and
(2) The defined contribution approach (DC), in which benefits are typically determined by the amount
contributed and the accumulated earnings on those contributions.

B. Pension financing also follows one of two general approaches:

(1) Pay-as-you-go (PAYGO or unfunded), with contributions from current workers and their employers
used to pay the pensions of current retirees; and
(2) Funded, with contributions invested in individual accounts that are used by workers to pay for their own
retirement benefits.

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Benefit Structures

The different types of benefit structures are normally classified as follows: :

 Defined benefit (DB),

 Defined contribution (DC) and;
 Notional defined contribution (NDC)

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Benefit Structures
Defined Benefit Schemes (DB)

 In a defined-benefit scheme, the benefits payable to an employee is determined primarily by criteria (a formula) other
than the value of the participant’s contributions and accumulated investment earnings.

 The benefits are most likely to reflect the wage or salary level at retirement, and perhaps the length of time that the
participant was in the scheme. There may be a minimum value.

 The benefit may be paid as a lump sum or as regular pension payments or both.

 If there are regular pension payments, they would normally be paid at least until the death of the participant. After the
death of the participant, payments may continue to be paid to a surviving spouse and any dependent children,
perhaps at a reduced rate.
 A retiree has a guaranteed benefit set by a formula specified on the onset
 The retirement benefit is independent of market performance.
 Employees are protected from the ups and downs of the market.
 The benefit is paid for as long as the retiree lives.
 The contributions to a defined benefit pension scheme are made by both the employer and the employee

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Benefit Structures
Defined Benefit Schemes (DB)

• A worker’s final benefits is known precisely (or at least in relation to final salary).
• The system can be designed to redistribute income by helping some groups. For example, income is redistributed
from high-income people to low-income people, from young to old etc.
• A worker’s contributions are not necessarily linked to his or her own benefits. Contributions go into a large trust
fund, and are not linked to the person who made the contribution. Benefits are defined by a formula which may
bear little or no relationship to the person’s payments into the system.

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Benefit Structures
Defined Contributions (DC)
 Contributions made by the worker and/or the employer are paid into an individual account for each member.
 The contributions are invested and the returns on the investment (which may be positive or negative) are credited to
the individual's account.
 On retirement, the balance in the member's account is used to provide retirement benefits. In particular, the balance
in the account is paid out in full (i.e. a lump sum) and used to purchase an annuity or converted to an annual pension.
 The contribution is known (defined) but the benefit is unknown. The benefit one receives at retirement is based on:
 The contributions made over the years and;
 The investment income generated on those contributions.
 A worker’s final benefit depends heavily on the investment returns earned over his/her working lifetime. This can
make future financial planning difficult, as a worker cannot know precisely, in advance, how much he/she will receive
on retirement.
 There is no guaranteed retirement benefit under a defined contribution plan.
 The employee bears the ultimate risk of investment performance.
 Complex and Costly to Administer
 Complex Regulations and Supervision
 Unpredictable Pension Amount (individual takes investment risk)
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Benefit Structures

Notional-Defined Contribution (NDC) scheme

In a Notional-Defined Contribution (NDC) scheme, the worker’s contributions to the public pension system are
assigned to his or her “virtual” or notional pension account. That is, each contribution is considered as personal
savings on a pension account, which yield a given return over time. The accumulation of these savings and returns
then define the benefit to which the worker is entitled once he or she retires.

Hybrid schemes
Hybrid schemes are those schemes which have both a defined benefit and a defined contribution element. A scheme
is classified as ‘hybrid’ either because both defined benefit and defined contribution provisions are present or
because it embodies a notional defined contribution scheme and, at the same time, a defined benefit or defined
contribution provision..

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Financing of Pensions

One common classification of pension system is in terms of financing method,

Pension plans are funded by contributions from employers and occasionally from employees. Funding is the setting
aside of money in advance to pay for the provision of pensions and other benefits when they fall due.

Defined benefit plans may be either funded or unfunded.

 In a funded scheme, contributions from the employer, and sometimes also from plan members, are invested in a fund
towards meeting the benefits.

 In unfunded schemes, no contributions are made to the scheme in advance and no investment fund is built up.
Instead the benefits are paid out by the employer when they fall due. This type of arrangement is called “Pay As You
Go”.

There are three principal methods of financing pension costs:

 Full Funding
 Partial Funding, and
 Pay-As-You-Go (PAYGO)

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Financing of Pensions

Full Funding

Fully funded is a description of a pension plan that has sufficient assets to provide for all the accrued benefits it owes
and can thus meet its future obligations.

In the fully funded system, the sum total of the pension contributions collected annually equals the sum needed for
the future payment of the pensions earned in that year. When the fully funded system is applied, each generation saves
the funds needed for its own pensions.

Thus a plan is referred to as actuarially fully funded when the assets set aside at any given time, including future
earnings from these assets, are deemed adequate to meet all future pension payments.

Fully funded pension systems require that the individual’s contributions are invested into a fund. The returns to this
investment are capitalized, which provides the individual with an amount that he or she can collect at retirement. The
other option is to convert this amount into an annuity (a flow), and obtain a flow of pension benefits each month.

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Financing of Pensions

Pay-as-you-go (PAYGO)
 Pay-as-you-go is a generic term for pension systems whose costs are not financed in advance.
 The contributions of a given year arising from the working generation are used to pay the benefits in the same year
to the previous generation of retirees.
 With PAYG systems, all contributions to the system are mutualized in a common pool, and pensions benefits paid
out of that pool according to some formula.
 Contributions to the pension system are used to pay the pension benefits of current retirees. Then, as time passes,
the ones who were paying become the ones who receive a benefit, paid by the new generation of “youths”, and so
on generation after generation.
 In the PAYGO system, both the contributions and the benefits are defined by the government,
 No reserves are accrued and thus no investment activities are undertaken. Contributions are expected to be
adequate to pay benefits and administrative expenditure in a given period.
 Contributions from workers and/or employers alone are usually insufficient to pay benefits, so the responsibility of
financing the shortfall rests on the government, which will tax its citizens to cover the cost.

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Financing of Pensions
Partial Funding
 Partial funding, as the term implies, falls in between full funding and pay-as-you-go. Thus, in a partially funded
system, these two alternative ways of financing earnings-related pensions are combined.

 A partially funded system means that some of the pension contributions collected annually from employers and
employees are placed into funds, i.e. saved and invested for pensions that would be paid in the future. The
remaining annual contributions are used directly to cover pensions paid in the same year.

 From the perspective of pensions paid, a partially funded plan means that some of the pensions are financed by the
pension contributions collected during the current year and some by assets deposited earlier in funds and their
returns.

 In a partially funded system, each generation pays a portion of the pensions of the currently retired generations, but
also saves a portion for its own future pension.

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 Multi-pillar Pension
In general, there are three main functions of pension systems: saving, redistribution and insurance functions.
Most national pension systems are based on multi-pillar schemes to ensure greater flexibility and financial security to the old in contrast to
reliance on one single system.

Zero pillar
This is non-contributory pillar, aimed at alleviating poverty among the elderly, and permitting fiscal conditions. It is usually financed by the state
and is in form of basic pension schemes or social assistance. In some typologies, the zero and the first pillar overlap
First pillar
Pillar 1, sometimes referred to as the public pillar or first-tier, answers the aim to prevent the poverty of the elderly, provide some absolute,
minimum income based on solidarity and replace some portion of lifetime pre-retirement income. It is financed on a redistributive principle
without constructing large reserves and takes the form of mandatory contributions linked to earnings such as minimum pensions within
earnings-related plans, or separate targeted programs for retirement income.
Second pillar
Pillar 2, or the second tier, built on the basis of defined benefit and defined contribution plans with independent investment management, aims
to protect the elderly from relative poverty and provides benefits supplementary to the income from the first pillar to contributors. Therefore, the
second pillar fulfils the insurance function. In addition to DB's and DC's, other types of pension schemes of the second pillar are the contingent
accounts, known also as Notional Defined Contributions or occupational pension schemes.
Third pillar
The third tier consists of voluntary contributions in various different forms, including occupational or private saving plans, and products for
individuals.
Fourth Pillar
The fourth pillar is usually excluded from classifications since it does not usually have a legal basis and consists of "informal support (such as
family), other formal social programs (such as health care or housing), and other individual assets (such as home ownership and reverse
mortgages)."
These 5 pillars and their main criteria are summarized in the table below. 63
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