U.A.E.'s bright future: Pioneering end-of-service benefits reforms

Last week, the U.A.E. shared exciting insights into its pension reforms, charting a path toward a groundbreaking voluntary end-of-service benefits (ESB) funding system. This development isn't just significant; it's a crucial step in fortifying the U.A.E.'s role as the premier financial center in the Middle East.

Let’s delve into some key observations and a few concerns to be addressed:

1. The 'Guaranteed Fund': One concern revolves around the widespread use of a "Guaranteed Fund," typically tailored for lower-income blue-collar workers and cautious white-collar professionals. Surprisingly, these funds don't always deliver their promised returns. Many U.K. readers will be familiar with Equitable Life's With-Profits Guaranteed Fund, which witnessed a spectacular and very high-profile failure in 1999.
   1. Guaranteed funds tend to operate with an opaque charging structure, hiding the real costs and charges which are controlled primarily by the Actuary to the Fund. It's essential to mandate clear transparency, disclosing both their financial status and comprehensive operational expenses. Although introducing fee caps seems reasonable, it might face resistance from Guaranteed fund managers who argue for operational flexibility.
   2. The 'Market Value Adjustment Factor (MVAF)': In times of economic uncertainty, Guaranteed funds may temporarily halt benefit distributions or apply perplexing deductions known as an MVAF, which are introduced to protect the residual investors and penalize those exiting from the fund. This raises questions about their financial stability.
   3. Investment mix: the Guaranteed fund for the new U.A.E. Voluntary arrangement appears primarily to invest in low-risk U.S. Treasury Bonds, without any Shariah-compliant assets. It will also come with foreign exchange risks. This investment approach may struggle to provide returns that outpace inflation over the long term, especially without some degree of diversification or reasonable fee controls.
   4. Equal Treatment for All: The principle of treating all investors equitably is commendable. However, it also means that employers with large workforces investing in the Guaranteed fund receive identical treatment as self-employed individuals, including in respect of the financial costs.
2. Expanding Investment Horizons: One observation is that offering a comprehensive range of investment options, encompassing both Shariah and non-Shariah-compliant assets, is essential to cater to a diverse investor base. A well-designed "default" fund tailored for blue-collar and lower-paid workers should be part of this offering, perhaps with the "Guaranteed Fund" as an option but not the default choice.
3. Farewell to Salary Linkage: The removal of the salary linkage for future ESB obligations signifies a significant change. Rather than calculating mandatory end-of-service benefits based on the final salary at exit, these benefits will be determined when employees transition from the current ESB regime to the new voluntary defined contribution funding system. While this is favorable for sponsors keen to cap their past service obligations, it might dampen the enthusiasm of employees, potentially leading to less favorable outcomes. Improved results will depend on optimistic future investment performance, which, at the moment, may appear uncertain.
4. The Role of a Trustee: The absence of a trustee in the framework suggests that employers become fiduciaries. In such a scenario, employers must carefully weigh the implications of participating in the voluntary ESB arrangement. There's also a notable role for custodians in safeguarding the "best interest of members." Nevertheless, custodians typically lack this responsibility, which a trustee is well-equipped for. It's advisable to include a trustee for enhanced oversight over various parties, such as provider/administrator and fund managers, and to ensure compliance with regulations set out by the Securities and Commodities Authority (ESCA), a standard practice in pension systems worldwide.
5. The Puzzle of Provider Market: Initially, the provider market appears to offer limited opportunities for insurance companies and banks. However, this landscape may evolve over time. Currently, employers (and ultimately employees) must choose an investment fund, potentially limiting competition and excluding many providers. A competitive and open financial services environment has historically proven to be the most effective route for serving investors.
6. Call for Reforms: This journey has just begun, and there's ample room for further improvements. Simplifying contribution rates by rounding them up to, for example, 6% and 9% from the current 5.83% and 8.33% levels could be a pivotal step. Additionally, imposing a cap on fees and charges, akin to Poland (60bps/0.6%) or the U.K. for default options (75bps/0.75%), can substantially enhance employee payouts and streamline the transition away from the salary linkage.

In summary, the introduction of a voluntary ESB funding system marks a promising beginning. With strategic adjustments, these reforms can unlock their full potential, ensuring enduring success and a prosperous financial future for the U.A.E.

Author

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Michael Brough

Senior Director, Integrated & Global Solutions

email Email phone +971 50 189 5816

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