Selecting the right retirement savings plan is one of the most important financial decisions you can make. In Kenya, the two main options are a pension fund or a provident fund. Which one is best for you? This guide examines the key differences and helps you decide.
Introduction
Both pension and provident funds aim to provide income for retirement. But they use different approaches.
- Pension funds provide a regular income during retirement. Contributions are invested and grow over time. At retirement, you use the accumulated funds to buy an annuity that pays out monthly.
- Provident funds pay out a lump sum at retirement. Contributions go into an individual account. At retirement, you withdraw the full balance as one payment.
Understanding how each type works is crucial before choosing one over the other. This article looks at the key features, benefits and drawbacks of pensions versus provident funds in Kenya.
How Pension Funds Work
Pension funds operate on a pooled basis. All members contribute to a central fund which is collectively invested. Pension funds aim to replace income at retirement, providing a regular monthly payment.
Here’s how they work:
- You (the employee) and your employer make monthly contributions to the pension fund
- Contributions are invested in a range of assets like stocks, bonds and property
- Over your working life, contributions grow through investment returns
- At retirement, your accumulated contributions are used to buy an annuity from an insurer
- The annuity provides a guaranteed regular income for life to replace your salary
Two types of pension funds exist in Kenya:
Defined Benefit (DB) Schemes: A target pension amount is defined upfront (e.g. 50% of final salary). Contributions are set at a level aimed to meet the target. Popular with public sector employees.
Defined Contribution (DC) Schemes: Contributions are defined but the final pension depends on investment performance. Most private sector schemes are DC plans.
Key advantages of pension funds:
- Guaranteed income – annuities provide a regular income for life
- Consistent contributions – costs are spread over your career
- Investment gains – benefits from long-term market growth
- Spousal benefits – many schemes provide survivor pensions
Potential disadvantages:
- Annuity rates – low interest rates can reduce annuity payments
- Investment risk – market downturns negatively impact your pension
- Inflexibility – limited control over how funds are invested
- Early exit penalties – transferring out can be expensive
Overall, pension funds offer a lower-risk approach to retirement saving aimed at providing a secure income. But the fixed structure limits flexibility.
How Provident Funds Work
Provident funds take a different approach focused on building up a retirement lump sum. Key features include:
- You and your employer contribute to your individual account
- You decide how the funds are invested from available options
- At retirement, the account balance is paid out as a tax-free lump sum
- No regular income or annuity is provided
- You manage and invest the lump sum on your own after retirement
Some key advantages of provident funds:
- Flexibility – you control investment choices and fund access
- Lump sum – full account balance paid out at retirement
- Potentially higher returns – self-direct investments for growth
- Early access – can make withdrawals before retirement
Potential disadvantages:
- No regular income – lump sum must be managed carefully
- Investment risk – poor choices can reduce the fund value
- Reduced security – no spousal benefits or guarantees
- Lack of discipline – accessing funds early reduces retirement savings
Overall, provident funds provide more flexibility and control over your retirement savings. But this comes with greater responsibility to manage investments wisely. There is also higher risk if funds run out later in retirement.
Comparing Pension and Provident Funds
When deciding between pension and provident funds, weigh up these key factors:
Retirement Income
Pensions offer guaranteed lifetime income from an annuity. Provident funds provide a lump sum that must be invested to generate income.
Investment Risk
Pensions pool risk over many members. Provident funds place investment risk fully on the individual.
Costs
Pension fees are fixed as a percentage of salary. Provident funds have individual charges based on funds chosen.
Flexibility
Provident funds allow full access to savings before retirement. Pensions impose penalties on early withdrawals.
Death Benefits
Pensions include survivor benefits. Provident funds pay account balance to dependents tax free.
Transferability
Which Is Better for You?
Transferring pension savings can result in losses. Provident funds are fully portable between employers.
The right option depends on your individual needs and circumstances:
Pensions suit those who:
- Prioritize fixed income after retirement
- Prefer low investment risk
- Change jobs infrequently
Provident funds suit those who:
- Prefer flexibility and control over savings
- Are comfortable directing own investments
- May access funds early or change jobs
Also consider the type of retirement benefits your employer provides when making your choice.
Tips for Deciding
- Review projected retirement income versus expected living costs
- Understand all fees, charges and withdrawal rules
- Consider your risk tolerance and investment experience
- Discuss options with a financial advisor
- Contribute as much as possible, the earlier the better
Conclusion
The differences between pensions and provident funds are significant. Pensions focus on secure lifetime income while provident funds maximize flexibility and control. Weighing up your priorities as well as employer schemes will help you determine which approach is right for you. Seeking professional financial advice can provide guidance to ensure your retirement savings strategy meets your long-term needs.
