Micro-pensions: Issues and challenges

A micro-pension plan has a distinct accumulation phase as well as a pay-out phase. During the accumulation phase, a member contributes towards accumulating balances. The value of such accumulation depends on the amount of contributions less pre-retirement withdrawals plus returns (net of investment management expenses) obtained from the investment of funds.

It is usual for administrative expenses to be borne by the members collectively.These howeverneed to be transparent and benchmarked. The accumulation phase is followed by the pay-out phase, which commences after retirement in most cases. During this phase, the member receives income from the pension fund either as a lump sum or in a phased manner.

Product Features

A pension product for low-income groups should be designed to take into account the constraints faced by, and the needs of these individuals. As income streams may be uncertain or volatile, the product should offer a degree of financial flexibility calling for low or no minimum contribution requirements so as to encourage membership. However, contributions that are set too low or which are paid in a sporadic manner may not provide sufficient income security.

Experience with micro-savings indicates that low-income group’s prefer lower-value and frequent deposits rather than infrequent larger-value deposits. As there are competing demands on their resources, it is difficult for these groups to accumulate large amounts. In order to facilitate the making of frequent deposits and to remove prohibitive time and travel costs, convenient door-to-door deposit collection is favoured. Furthermore, the product features should be uncomplicated to enable all individuals, including those with low levels of financial literacy understand and monitor them.

The duration of pension products should be long-term, though a roll-over option after each ten-year term may be less daunting for low-income groups. The age at which the first withdrawal is permitted may or may not coincide with the retirement age.

The other design alternatives are to provide either easy withdrawal options or loans against deposited amounts. But these features result in increased transaction costs and reduces the period over which compounding occurs; resulting in a lower level of accumulated balances and hence retirement income. The trade off is between current needs and future income security in retirement.

Risk Management

In the pay-out phase, longevity, investment and inflation risks need to be addressed. In addition, survivors’ benefits and disability insurance are also essential. Survivors ‘benefits are particularly important.

Longevity risk derives from the fact that although each individual will die eventually; the age, the cause, and the place of his or her death are not known. Some may die within a short period after retirement, while others may live for a much longer period. The latter category of persons may find their financial resources exhausted, while those dying early in retirement may not face this challenge. The earlier the age at which the first withdrawal is permitted, the longer the period for which the accumulated balances will be required to be used to finance income in old age.

Investment risk refers to the risk of return from the portfolio that the pension fund invests in. In the risk-return continuum, a lower degree of risk is desirable for micro-pension plans because of the lower risk-bearing capacity of the low-income population. In order to ensure an adequate rate of return on small deposits, the transaction costs involved need to be kept low. This is a challenge that must be met both through technology-based solutions and deliberate efforts to realize economies of scale and scope.

Taking into account the lengthy time horizon within which micro-pensions operate, inflation risks are important, and particularly so in view of the limited resources of the poor. In much of Africa, inflation risk is one of the main reasons why savings for old age are placed in assets, such as by investing in land, housing and livestock.

Micro-pensions must offer a reliable means for the collection of small-value deposits on a frequent basis at locations convenient to the customer. Given the large demography in Nigeria, a challenge is to put in place a truly nationwide distribution channel for micro-pensions.

Micro-credit loans are essentially short-term in nature and range between one and three years, with a one-year term being the most common. Although repeat loans are often observed, the time horizon is usually not as long as that of micro pension schemes. Hence, the two financial services (loans and deposits) may not overlap entirely and to that extent there may not be cost savings.

Micro Pensions functions include the following; firstly, the reliable collection of contributions, taxes and other receipts, including any loan payments. The second concerns the payment of benefits for each of the schemes in a timely and correct way. The third involves securing financial management and productive investment of provident and pension fund assets. The fourth core function is maintaining an effective communication network, including the development of accurate data and record-keeping mechanisms to support collection, payment and financial activities. The fifth is the production of financial statements and reports that are tied to providing effective and reliable governance, fiduciary responsibility, transparency, and accountability. The sixth function, it is to provide customers with appropriate financial education and to increase financial literacy.

Communication

The communication strategy with potential customers should be creatively managed. For instance; for products such as micro-pensions that operate with a lengthy time horizon, offering fixed interest rates may be difficult; accordingly, flexible interest rates may be more appropriate. The concept of flexible interest rates may however be hard to explain to customers with low levels of financial literacy. It is therefore incumbent upon institutions to effectively explain the product to customers, it’s important that the potential customers are equipped with sufficient knowledge to enable them to explain the products to their family members.