Opinion: Cayman’s broken pension system needs radical reform

By Simon Cawdery, Compass Columnist

It’s time to talk about pensions again. Before going into detail, some quick reflections on why pensions in Cayman are so dis-loved, and why the distaste is quite unique.

In most developed countries, individuals consistently contribute as much as possible into their pensions, going right up to the legal maximum. Cayman couldn’t be more different. Here the thought of contributing to a pension generates ennui at best and hostility at worst.

But why?

In most countries, with an income tax system, contributing to a pension is a pre-tax payment, meaning that pension contributions reduce your tax bill while enabling you to receive tax-free capital growth. In other words, there’s a huge economic incentive for people to contribute to a pension – an incentive that doesn’t and can’t exist in Cayman.

Against this backdrop, it is perhaps more obvious why Cayman is in the situation it is. If people had an economic incentive to care about pensions, they probably wouldn’t be so disliked and there would be more concern paid to their existing flaws. As it is, despite the woeful situation of the pension system, the regulations and the plan options available, there never seems to be enough interest or angst to effect change. Hopefully this article can motivate more to care about something that impacts every single one of us and is, unfortunately, under-appreciated.

The basic problems

Three flaws exist in Cayman’s system:

1. Contributions are too low;
2. The retirement age is too young;
3. The regulations prevent optimal investment strategies being followed.

The result is that the government will have to fund more people as they age, which is a hidden financial burden and not properly being accounted for (although recently acknowledged at least).

The valid counterargument (in some instances) is that many people don’t rely on the pension system for their retirement because they have invested in property or other assets.

Good news for these people as they have taken responsibility for planning for their future and will be better protected against the economic vagaries of retirement and have much less to worry about.

One problem with this argument is that it only applies to a tiny minority of people. A second problem is that home ownership only helps in retirement if people are willing to sell their houses and downsize, thereby freeing up capital, since owning a house won’t pay for groceries.

Some options

What about those who don’t self-prepare? One perfectly valid approach is for government to tell individuals they must prepare for their own retirement and then if they fail to do so, warn them, in no uncertain terms, that there will be no safety net

In a theoretical world this approach should work. The threat of destitution later in life would be so pressing and worrisome that everyone would prudently prepare by saving money today and investing it for the future. Unfortunately, humans rarely conform to economists’ theoretical models.

What we know, all too well, from economics and psychology, is that humans are generally terrible at preparing for the future. Take a very Cayman example: We all know what hurricanes can do, yet there’s a huge rush 48 hours before any storm to stock up on non-perishables at the supermarket, instead of preparing at the start of hurricane season. Simply put, it’s because humans are bad at preparing for the future.

If we are so bad at preparing for hurricanes, which happen at predictable times of the year and with known ferocity, then it is perhaps no surprise that we are even worse at preparing for retirement. After all, no one who isn’t retired has ever experienced retirement. We have all experienced at least one hurricane season so we know what we should do, but still don’t do it. Only when we retire, can we learn to regret the decisions we made in our 20s, 30s and 40s. But, by then, it’s far too late.

With this approach binned, we are left with two other options. One of the remaining two we shall call the “government option”. In this scenario we recognise that we are all terrible at preparing for retirement so why bother?  Instead, we make it government’s problem. Government will provide a minimum level of income to ensure no one is below the ‘poverty line’ in retirement. That way the problem is managed by an entity that can take professional advice and plan for the long term.

Can you hear the alarm bells ringing?

First do you trust the government to adequately manage its affairs for the next 30 years, so your retirement is safe? Second, what if they get it wrong? Are governments such good stewards with money that this is the best option? Third, how do they pay for it? In Cayman, the majority of revenue the government collects comes in the form of tourism taxes, financial services taxes and import duty. Imagine if one of those experienced a sustained slowdown.

The ability of government to meet its obligations is dependent on factors over which it has no control. Government can’t control the number of tourists, it can’t easily control the number of people who live here and therefore import goods, nor can it control financial markets. Thus, the viability of a pension system run by the government is subject to such incredible unknowns that it seems perilous to rely on such an approach. Bear in mind the earlier point about Cayman’s government not even properly accounting, today, for its future liabilities.

Let’s return to Cayman’s current, much maligned, system

Before going there, a quick bit of maths to set the scene. Imagine you want to retire on $60,000 a year. How much needs to be in your pension account? The number, according to the actuaries, is almost a million dollars. Have a look at your pension account. Is it showing a balance of $200,000? That means you will retire on $15,000 a year. Could you possibly, in Cayman, live on that amount? Of course not! And yet, many may not even have $200,000 in their account, meaning their retirement prospects are even worse.

Many people in Cayman will retire on incomes that are woefully inadequate and suffer forms of hardship because of this. This will force the government to help out with ex-gratia payments or subsidies. But those subsidies are not accounted for by the government. They are not remotely in the government’s forecasts because this is often considered a ‘private sector problem’. But poverty, caused by poor government policy, can’t simply be washed away as being a problem for the private sector. Private sector employees vote, too, and if poor and retired, they will demand government support. Therefore, we need to fix the current system since government won’t be able to afford to fix the future problem.

What about some solutions to make things better?

1. First do no harm

An axiom that usually applies to the medical profession but one that shouldn’t be forgotten by our legislators in today’s climate. The current pension system has alarming faults. One path would be to fix those faults. But absolutely, definitely, categorically, let’s not make those faults worse, however ‘well-intentioned’.

Allowing people to withdraw funds from their pensions is a tragically short-sighted policy.

We are in the midst of a cost-of-living crisis and people are falling behind on their mortgage payments and struggling to provide for their families. There’s no doubting the veracity of this problem. The solution is to solve this problem through targeted relief, not through an inefficient poor second cousin of a solution that will only serve to amplify future problems.

There are almost certainly better solutions. Let me float one idea for those struggling to buy a property, or needing to reduce their debt because of higher interest rates. Why doesn’t the government either directly or through a credit bureau offer secured loans to the needy, collateralised by a second charge against the property (behind the bank) with interest costs deferred and perhaps substantially reduced by the government getting a small equity stake so that it can recoup its capital plus more.

This would reduce the cash burden on distressed borrowers while freeing up their capital for day-to-day expenses and allowing them to retain a major stake in their property but not costing the government financially in the longer term.

Obviously, this would all appear explicitly on government accounts, but better to fix a problem properly and transparently than use a policy that hides its true cost and makes future problems materially worse.

2. Inadequate contribution rates

10% per year is simply not enough. To get to something that is remotely adequate, contribution rates must rise probably to 20%.

This will be painful and unpleasant, particularly in a cost-of-living crisis, but the longer this is delayed the worse the eventual problem will be.

Perhaps this could be phased in: 1% increase each year in contribution rates for 10 years. That won’t harm people as much as a 10% hit will and could perhaps be more palatable. If there were ever a signal that proved the importance of this, just look at the contribution rates for Parliament which are at 12%, and the judiciary which are at 20%. There’s absolutely no criticism implied in this analysis; the purpose, rather, is to illustrate what should be required for all, and what is already accepted as necessary in certain elements of the public sector.

3. Raise the retirement age

In an ideal world, we would all want to retire as early as possible and enjoy our older years free from worries and anxieties, travelling, exploring and enjoying new pursuits. We simply don’t live in an ideal world. Indeed, a lot of people enjoy the work they do and would welcome the opportunity to work longer. For others, the prospect of working longer may be depressing and misery-inducing, but if it means being able to afford food, rent and utilities, better to have work than not.

Our current system actually penalises people for working longer since they can’t contribute into a pension and employers are encouraged to let people retire. As we live longer, the retirement age will have to rise to 65, and then 70. Again, this can be phased in, but should be done this decade. If you are currently unpersuaded, look at this way: We previously assessed that an individual needs a million dollars to retire on $60,000 per year (if they retire at 65).

But if they retire at 67 or 69, then that required pension pot sum declines by $50,000 for every two years longer you work. That’s a huge improvement in every retired-person’s financial situation. Just re-check your pension statement to see how material a sum of $50,000 is.

4. Scrap the arcane investment restrictions

There’s a perceived view that the legacy pension providers in Cayman have done a terrible job in delivering investment returns for members. This isn’t entirely wrong; returns haven’t exactly been great. Part of that is poor investment returns, a lot of it is extremely high costs (due to inefficiencies), but part of it is also due to the archaic (some might say idiocy) of the investment regulations. Twenty years ago, a group was formed to advise on sensible changes to the investment regulations for the private sector pension system; 20 years on, absolutely nothing has changed.

The current investment regulations for the private sector are simply not fit for purpose. Plaudits are given to the public sector pension plan for its returns, potentially rightly so, but we aren’t comparing like-with-like. The public sector has almost 80% of its assets in equities. The private sector is legally prohibited from doing so. Thus, government rules are deliberately harming the private sector. Does that make any sense? Ask any actuary and they will advise that to deliver long-term returns one should invest in long-term assets. Cayman’s private sector rules actively forbid that. This is not to excuse some of the expenses and ineptitude of the private sector, but at least give them a level playing field. Create investment regulations that are fit-for-purpose and the pension system has a chance of delivering on. As it currently stands, it has no chance.

5. Scrap the private sector system

There’s an argument made that we should scrap the private sector and allow the public sector plan to be a monopoly provider of pensions. In some respects, there are merits to this – economies of scale etc. But, as already mentioned, one of the main problems the private sector has faced in delivering returns to members is the harm caused by antiquated investment restrictions. At least level the playing field before rushing to conclusions. Philosophically though, competition is usually a positive thing. Competition has the ability to encourage novel thinking, cost reduction and innovation, which means that legislating for a monopoly seems like a bad policy position.

Whether people can be motivated to care about pensions is something beyond our control, but hopefully policy decisions can be made based on logic and sense, thereby improving Cayman’s long-term prospects and the retirement prospects of every Caymanian, whether public or private sector-employed.

Simon Cawdery, CFA, is an investment manager and governance professional who lives and works in the Cayman Islands. He writes regularly for the Compass on business and finance matters.