PENSIONS: A NEW DAWN
Authored by: Jamie Liddington
Following the publication of Towers Watson’s recent report entitled End of Service Benefits in the Middle East (2014), there has been a revival of interest in pension schemes in the UAE as a potential replacement of the End of Service Gratuity scheme. In this article, Jamie Liddington, Senior Associate at Hadef & Partners, reviews the End of Service Gratuity scheme and considers the advantages and disadvantages of replacing it with defined contribution pension plan. Pension entitlements for those who are employed in the public sector are primarily governed by Federal Law No 7 of 1999 (UAE Pensions and Social Security Law) and fall outside the scope of this article.
End of Service Gratuity
End of Service Gratuity (“ESG”) (or “severance pay”) has existed in the UAE for over 40 years. The purpose of the ESG scheme is to provide employees with a source of income to cover any periods of unemployment following termination (including retirement). ESG is calculated with reference to (i) the employee’s remuneration (which may include commission and non-discretionary bonus payments) and (ii) length of service, but the maximum ESG payment is equal to two years’ remuneration. Unless the employment is terminated “for cause”, the UAE Labour Law requires all employers to pay an employee ESG on termination of the employment relationship subject to the employee satisfying the conditions set out in Article 132 of the UAE Labour Law.
For the vast majority of the period in which ESG has existed, it has, for the most part, been a very effective and popular entitlement. The rapid growth and success of the UAE has been in no small part due to its ability to attract talented professionals from around the world but those same professionals often leave the UAE after a number of years either to continue their careers elsewhere or to retire. In both cases, one of the major attractions of the ESG scheme is that the employee receives a cash lump sum and avoids the administrative headache of having to manage accrued pensions or saving scheme entitlements in another country.
But the ESG scheme is not without its detractors and the criticisms of ESG have grown louder over recent years.
The most likely candidate to replace ESG is defined contribution (“DC”) pension schemes.
Unlike ESG, a DC pension scheme typically requires the employer to make a specified contribution (usually expressed as a percentage of salary) into an account which is set up in the employee’s name and which is managed by a third party. The accumulated funds are held on trust for the benefit of the employee and are then invested and the returns on the investment are credited to the employee's account. On retirement, the employee's account is used to provide retirement benefits, sometimes through the purchase of an annuity which then provides a regular income.
In 2011 it was reported that the Department for Economic Development was engaged in discussions with the World Bank to introduce a State run DC pension scheme for foreign workers.
More recently, leading global professional services company Towers Watson have published the results of a survey of more than 170 organisations in the Middle East in relation to end of service benefits. In particular, the survey highlighted that:
“The most popular way by far of enhancing end of service benefits (“ESBs”) is to offer a separate DC pensions or savings plan and the number of respondents reporting that they offer a separate plan as an enhancement has increased.
The prevalence of supplemental DC arrangements in the Middle East remains stable at close to 30% of participants.”
It is becoming clear that the continuing education of the UAE workforce has resulted in growing support for the introduction of new law compelling employers to provide access to a pension scheme as an alternative to ESG.
Comparing the two
Pension schemes offer a number of advantages depending on the perspective of each party. For employees, the main advantages are:
- the pensions provider will, in most cases, advise and implement an investment strategy based on the employee’s appetite for risk. This is likely (though not guaranteed) to result in a return so the capital sums which accumulate are “working” to provide the employee with an enhanced benefit rather than sitting in the employer’s accrual account where the employer will gain the benefit of interest;
- Pensions are less vulnerable to the possibility of payments being forfeited (or subject to deductions) in the event that there is a dispute arising out of the termination of their employment or where the employer becomes insolvent. Where an employee’s employment is terminated under Article 120 of the UAE Labour Law, Article 139(a) states that the employee will forfeit any entitlement to receive ESG. As currently drafted, the UAE Labour Law arguably creates an incentive for employers to find ways to terminate an employee’s employment for a specific cause and without notice under Article 120;
- Pensions benefits are paid at a nominated retirement age and this can prevent employees giving into the temptation to spend their retirement income before they reach that age (e.g. if they leave one job mid-way through their career and receive a gratuity payment on termination).
For employers, the main advantages of a pension scheme are:
- A generous pension scheme can be a valuable tool in retaining existing staff while attracting the best talent;
- The structure of a pension scheme avoids the difficulties which some companies find themselves in when managing accrued gratuity liabilities. The employer should maintain sufficient funds to meet accrued ESG liabilities but there is no strict legal obligation on employers to do so and many employers fall behind or fail to do so entirely;
- Having a well structured and documented scheme can avoid Court disputes relating to the proper calculation of gratuity payments.
But for every advantage there is a disadvantage. ESG supporters highlight the fact that well over 80% of the UAE population are expatriates and that given the transient nature of the UAE workforce, most would prefer not to have to wait until retirement to receive income from a foreign based scheme. It is this feature of the ESG scheme which wins support among the expat population. If pension providers are able to offer a portable pension scheme where the accumulated funs can be transferred at the employee’s request within an international network of affiliated providers, it is likely that DC pension schemes will become far more popular in the UAE. However, ESG supporters also claim that the introduction of any State run pension fund would be expensive and time consuming and that the cost of the proposed implementation of such schemes is disproportionate to the benefit that will be delivered as a result.
Can employees have both?
Where an employer provides the employee with access to a pension scheme instead of ESG, it must not be less beneficial than the ESG entitlement and the employee remains entitled to opt for whichever is the more favourable benefit of the two.
However, that is not to say that a generous employer cannot offer employees both ESG and a defined contribution pension. Although the cost to the company would need to be carefully considered, any employer who was willing to provide both entitlements to its employees is likely to reduce staff turnover and be an attractive prospect to those who are looking for a new role.
Driving forces for change
In England, recent changes to pension legislation introduced the concept of auto-enrolment in order to make it more difficult for employees to avoid contributing to some form of retirement savings plan. In that instance, one of the main forces of change was the Government’s need to address the growing pension deficits and to reduce the population’s reliance on the State. Similarly, increases in the national retirement age are intended to keep the population working for longer in order to keep pace with anticipated increases in average life expectancy. But the same factors do not apply in the UAE, or at least, they are of less concern to the Government as the expat population of the UAE presently have very limited rights to remain in the UAE after reaching the retirement age (which was increased from 60 to 65 in 2011). Furthermore, given the fact that there is no State pension entitlement or welfare scheme available to expats, the UAE Government does not share the same concerns of having to provide a source of income to those who have reached the retirement age.
However, the UAE Government is keen to address the growing problem of expats sending salaries and other funds abroad as part of their savings strategy. By implementing a State run pension scheme or creating an obligation for employers to implement a DC scheme, the monthly contributions made by employees from salary will reduce the levels of disposable income. In turn, this is likely to have a direct (reducing) effect on money being sent out of the UAE.
It is unlikely that there will be any introduction of new pension law in the near future but there is a growing demand for pension plans in the UAE. Towers Watson report a five year increase in companies offering a DC pension entitlement to employees from 34% to 48% and there is no reason to expect this trend to slow down in the build up to Expo 2020 with employers trying to attract and retain top talent.
Article originally published in Legal 500.
This article, including any advice, commentary or recommendation herein, is provided on a complimentary basis without consideration of any specific objectives, circumstances or facts. It reflects the views of the writer which may, in some cases, differ from those of the firm, especially in the developing jurisdiction of the UAE.