Block 3 – Tutorial 5

Exercise 1(Calculating a DB Pension)

Solution:

AR= 1/80
FPS →Averaged over the last 3 years to retirement
FPS = (R170 000 + R180 000 + R200 000)/3
FPS = R550 000/3
FPS = R183 333.33

PS = 01 Feb 1985 – 01 June 2017

PS = 32 years 4 months (4/12)
PS = 32.33

P= AR × FPS × PS

1
P= ×183 333.33 ×32.33
80

P=R 74 089.58 p . a .

Exercise 2 (Net Replacement Ratio)

Solution:

Taxable Income = R400 00 – R50 000

Taxable Income = R350 000

At 25%
R200 000 x 25% = R50 000

R350 000 –R200 000 =R150 000

At 40%
R150 000 x 40% = R60 000

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Total Tax = R50 000 + R60 000
Total Tax = R110 000

After Tax Income = R400 000 – R110 000

After Tax Income before retirement = R290 000

NRR→ measure of the extent to which a person’s income has fallen in

retirement

After Tax Income after Retirement

a) NRR= After Tax Income before Retirement
x
0.1=
R 290 000

x=R 290 000 ×0.1

x=R 29 000

Mr. Brown’s net income has dropped by R29 000

After Tax Income after Retirement

NRR=
After Tax Income before Retirement
x
0.9=
R 290 000

x=R 290 000 ×0.9

x=R 261 000

R290 000-R261 000 = R29 000

After Tax Income after Retirement

b) NRR= After Tax Income before Retirement

x
0.25=
R 290 000

x=R 290 000 ×0.25

x=R 72 500

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 Mr. Brown’s net income has dropped by R72 500

After Tax Income after Retirement

c) NRR= After Tax Income before Retirement

x
0.50=
R 290 000

x=R 290 000 ×0.50

x=R 145 000

Mr. Brown’s net income has dropped by R145 000

Exercise 3(Voluntary Early Retirement Benefits)

Solution:

AR = 1/60

NRA = 65 years

Joins = 10 Oct 1990

Early Retirement = 1 July 2014 at age 61

FPS = R220 000

PS = 1 Oct 1990 – 1 July 2014

PS = 23 years and 9 months (9/12)
PS = 23.75

Voluntary Early Retirement

P= AR × FPS × PS × ERF

1
P= × R 220 000 ×23.75 ×0.84
60

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P=R 73 150 p . a .

Exercise 4(Costing Benefits)

Solution:

Let (S) = Salary and (T)- Tax payable

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a) Value of benefits = 2 × S+ 60 × S × 10=3.67 ( S )−(T )
b) Value of benefits = 4 (S)−(T )
40
c) Value of benefits = 2 × S+0.5 × 60 × S ×10=5.33 ( S )−(T )
10
d) Value of benefits = 2 × S+0.5 × 60 × S ×10=2.83 ( S )−(T )

Therefore if the member has dependents, benefit (c) wil be the best, as it
offers the highest benefit but benefit (c) will also be costly to the fund.

Exercise 5 (Portability Loss under DB Schemes)

Solution:

N
a) P= 80 × FPS

5
P= × R 100 000
80

P=R 6 250 p . a .

b) At 7=% salary increase up to NRA Clive would have been receiving

an FPS of:
30
R 100 000(1.07)

4
 R 761225.50

Thus pension in respect of service between 30 and 35 had Clive

remained in the scheme would have been:

N
P= × FPS
80
5
P= × R 761225.50
80
P=R 47 576.59

The loss that Clive has suffered by leaving the scheme is called
portability loss. Early leavers under a DC do not suffer such a high
portability loss because leaving a DC scheme is like changing your
bank.

Exercise 6 (Revalued Career Average Pension)

The following information relates to Mr. X who joined a DB scheme which

provides pension benefits on a revalued career average basis. Mr. X joined
the scheme on 1 January 2010 and reached normal retirement age on 31
December 2014. (Note that the short period of service is just for purposes of
simplifying the pension calculation). The scheme rules provide for an
accrual rate of 1/60.

Year of Service Annual Salary Revalue Index

2010 R100 000 160
2011 R110 000 167
2012 R120 000 190
2013 R130 000 200
2014 R140 000 205

Calculate the pension for Mr. X at the time of retirement.

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Exercise 7 (Factors which determine liability profiles of DB and DC
Plans)

What are the basic issues that determine the liability profile of DB and DC
schemes?

Solution:

Answer
 The liability profile depends on whether the scheme is a continuing
one or it is wound up. Typically a DB pension scheme would have
four liability classes-active members (i.e. people still working),
pensioners, deferred pensioners and spouses/dependents.

 For active members, this liability class is linked to future salary

growth which is unknown in advance and no asset exists which can
precisely match future salary growth.

 For deferred pensioners, pensioners and dependents, the liability

profile depends on the pension increase policy. How do benefits
payable to retired members increase each year?

 If benefit increases are linked to inflation increases e.g. through the

Retail Price Index or Consumer Price Index then investment assets
should be dominated by real assets whose return in the long term is
expected to move in line with price inflation e.g. equities, index-
linked bonds, property etc.

If benefit increase is fixed (e.g. 4% p.a.) then monetary assets should

dominate e.g. fixed interest securities, overseas bonds, cash etc. In a DB
scheme, assets should match liabilities of the scheme as much as possible.

Under a DC scheme there is no pressure to match assets and liabilities since

accumulated contributions typically buy a pension in the form of an annuity.
Members of a DC scheme are however vulnerable to inflation just like those
of a DB scheme hence real assets (equities) will be required. However, as
retirement date gets closer it may be necessary to switch from equities to less
volatile stocks like index-linked bonds to safeguard yields gained from
equities over the years. The main problem with equities is that they may
crash and wipe out gains made over the years.

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Exercise 8 (Calculating the expected pension under DB Plans)

Solution:

NRA =65 years

AR = 1/60
PS = 65-30 = 35
FPS = R100 000(1.07)^35
FPS = R 1 067 658.148

P= AR × FPS × PS

1
P= × R 1067 658.148× 35
60

P=R 622 800.5893 p . a

Exercise 9 (Death in service benefits, indexation and benefit commutation)

The following information applies to all members listed below:

Tax Year After-Tax Earnings

2011/12 170 000
2012/13 180 000
2013/14 195 000
2014/15 205 000
2015/16 115 000

Retail Price Index October 2010 100

(RPI) 2011 110

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 2012 120
2013 122
2014 125
2015 130

All members referred to below joined the scheme on 1/10/83 and are
currently on an annual salary of 205 000 p.a.

The pension scheme to which all the members referred to in this question
has the following design:

a) NRA 65 for both male and female members

b) Normal Retirement Pension fraction (accrual rate) - 1/80
c) Voluntary Early Retirement Pension- as in (b) above but reduced by
3% for each yearly early
d) Ill health Retirement Pension- as in (b) above and based on potential
service to NRA
e) Spouse’s Death After Retirement Benefits:
-Pension: 50% of member’s pension
-Lump sum guaranteed for 5-years

f) Death in Service Benefits:

-Spouse’s pension: 2/3 of member’s pension if he/she had retired due
to ill health prior to the day he/she died.
-Lump sum: 2 x Salary
g) Pension increases: Limited Price Indexation granted each October. Rate
of increase shall be lower of rate of increase in RPI or 5%.
h) Member’s contributions: 3% of Pensionable Salary
i) Pension commutation rate: R11 lump sum for every R1 of pension
surrendered

The following definitions are included in the Rules of the Scheme:

“Final Pensionable Salary” = Average of the last 3 “Pensionable Salary”
figures.

Calculate the retirement pension in each of the following cases:

i) Mr. Adams reached normal retirement on 1/11/2014

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 ii) Mr. Pires took early retirement due to ill health at age 51 on
1/10/2014
iii) Mrs. Henry took voluntary retirement at age 58 on 1/12/2014

iv) Mr. Viera died on 1/11/2014 having retired with a pension of 120
000 p.a. on 1/10/2011. Calculate the amount of pension he was
receiving before he died; and the benefits payable to his wife.

v) Mrs. Campbell died in service on 1/9/2014 at age 56. Calculate

the monthly contribution she was paying to the scheme at the time
she died; and the benefits payable to her husband.

vi) Mr. Adams opted to commute ¼ of his pension for a tax-free lump
sum. Calculate the lump sum and residual pension payable to him.

Solution:

i) Mr. Adams
Normal retirement = 1 Nov 2014
PS = 1 Oct 1983 -1 Nov 2014
PS = 31 year 1 month (1/12)
PS = 31.083

FPS = (195 000 + 205 000 +115 000)/3

FPS = R515 000/3
FPS = R171 666.67

P= AR × FPS × PS
1
P= × R 171666.67 × 31.083
80
P=R 66 698.94 p . a .

ii) Mr. Piers

Early Retirement due to ill health = 1 Oct 2014
NS
65-51 = 14 years
2014+14 = 2028
NS = 1 Oct 1983 -1 Oct 2028
NS = 45 years

9
 P= AR × FPS × PS
1
P= × R 171666.67 × 45
80
P=R 96 562.50 p . a .

iii) Mrs. Henry

Early Voluntary Retirement = 1 Dec 2014

PS = 1 Oct 1983 -1 Dec 2014
PS = 31 years and 2 months (2/12)
PS = 31.17

ERF
0 1
1 0.97
2 0.94
3 0.91
4 0.88
5 0.85
6 0.82
7 0.79

P= AR × FPS × PS × ERF

1
P= × R 171666.67 × 31.17 ×0.79
80

P=52 839.64 p.a.

iv) Mr. Viera

Passed away = 1 Nov 2014

Pension at Retirement = R120 000 p.a
Retired = 1 Oct 2011

Years in retirement: 1 Oct 2011 – 1 Nov 2014

= 3 years 1 month

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 1 Oct 2011 – 1 Oct 2012 = R120 000 x 5% (It should be 9.09% but see g)
= R126 000

1 Oct 2012 – 1 Oct 2013 = R126 000 x 1.67%

= R128 104.2

1 Oct 2013 – 1 Oct 2014 = R128 104.2 x 2.46%

= R131 255.56

Wife’s Benefit

Lump Sum = 5 years – 3.083 (lived 3 years and 1 month after retirement)
Lump Sum = 1.92 years

Lump Sum = R131 255.56 x 1.92

Lump Sum = R252 010.68

Pension Benefit = R131 255.56 x 50%

Pension Benefit = R65 627.78 p.a.

Mrs. Campbell

Passed away = 1 Sept 2014 at age 56

Contribution

Contribution = R205 000 x 3%

Contribution = R6 150 p.a.

Monthly = R6 150/12
Monthly = R512.5

Husband’s Benefits

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Lump Sum = R205 000 x 2
Lump Sum = R410 000

Pension Benefit = R85 661.67 x 2/3

Pension Benefit = R57 107.79 p.a.

FPS = (195 000 + 205 000 +115 000)/3

FPS = R515 000/3
FPS = R171 666.67

NS = (1 Oct 1983 -1 Sept 2014) + (65-56)

NS = 30 years and 11 months (11/12) +9 years
NS = 39.92

Mrs. Campbell’s Pension = 1/80 x R171 666.67 x 39.92

Mrs. Campbell’s Pension = R85 661.67

Mr. Adam

Tax-free lump sum = R66 698.94 x ¼

Tax-free lump sum = R16 674.735

Residual = R66 698.94 x ¾

Residual = R50 024.205

Exercise 10

Solution:

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Method 1: 55

Method 2: 30

Deficit (Why?)

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