Contributions, premiums always paid before benefits

THERE is one characteristic which is a permanent feature of the contractual savings industry. Contributions and premiums are always paid before benefits. The implication of this tradition is always that inflation will affect benefits more than premiums and contributions. If this is not regulated properly, it can lead to a systematic loss of the benefits by pensioners and policyholders when compared with the premiums paid in respect of them.

The Actuarial Equation of Value The contributions or premiums payable on any contractual savings products is determined using the actuarial equation of value. This is an equation of the present value of benefits to the present value of the contributions or premiums allocated to buy benefits. Of course there are parts of the premium allocated to pay for expenses and other parts allocated to pay for profits. In this discussion, we are only focused on that portion of premiums or contributions which has been set aside to buy benefits. At the inception of a fixed premium contract with a fixed sum assured, the present value of benefit payable is equal to the portion of contributions and premiums allocated to pay for benefits. Without inflation, this relationship would remain throughout the term of the policy.

Introduce inflation and things get very interesting. The real value of each subsequent contributions or premiums paid reduce over time because of inflation. But there is more.

The real value of benefits reducing even faster than the rate at which the real value of premiums is reducing. Over time, the real value of premiums will rise above the real value of benefits. The actuarial equation of value is thus only true at inception. At all other times premiums exceed benefits. In a hyperinflationary environment, the value of benefits is minuscule and insignificant.

Inequitable Generational Transfers of

contractual savings Contractual savings are usually pooled together and ownership of assets is forever changing as more money is paid into the fund and others receive their benefits. This pooling means assets are continuously automatically changing hands. As assets get transferred from one individuals to another, inflation distorts the way in which these assets are transferred and sometimes these distortions can systematic and therefore unfair. Hyperinflation magnifies these unfairness to a point where they are highly visible as happened in Zimbabwe in 2008. The essence of investing assets held in respect of contractual savings is that assets are invested over a given in order to earn a return. It is therefore imperative that there is a clear understanding of this process, so that the allocation of the investment return between individual policyholders and pensioners is done properly. Firstly, because dollars invested at different times in an inflationary environment do not have the same value. Dollars that were paid later buy much less than dollars paid in earlier.

It also means that the allocation of investment returns needs to allow for the differences in value between the dollars paid earlier and those paid latter. Put differently, a dollar paid earlier is worth more than a dollar paid latter. Mixing the two dollars as if they are the same results in loss of value for the person who paid the earlier dollar. If this adjustment is not done, then older valuable dollars are being exchanged for less valuable later dollars without any compensation. This phenomenon is results in a transfer of assets and benefits from older generations to the younger generation.

This generational transfer of assets explains how value was lost by pensioners and policyholders during the hyperinflationary era. ◆ Tapiwa Maswera is an Executive Director and founder of Global Worldview. He is an actuary, researcher, valuator of pension funds, a former member of the Justice Smith Commission of Inquiry into the Loss of Values in the Insurance and Pensions Industry. Feedbacktapiwa@acumenactuaries.com