MICRO PENSIONS – Questions & Answers
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What are micro pensions?
Micro pensions are financial products for old-age income security. A typical micro pension scheme is based on voluntary savings, accumulated over a long period and intermediated through financial and capital markets by a professional fund manager. The core elements of micro pensions are: o
Voluntary savings scheme
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Accumulated over a long period of time
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Administration and distribution mainly by micro finance institutions (MFIs)
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Contributions invested by a professional fund manager
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Defined contribution (in principle)
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Benefits dependent on investment returns
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At agreed withdrawal date the accumulated capital can be paid in lump sum or periodically via an annuity
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Why micro pensions?
Population ageing is the result of increasing life expectancy and falling fertility rates. Currently, one out of every ten persons in the world is over 60 years old. By 2050 the proportion of older people is expected to have risen to one out of every five persons. Furthermore, while currently nearly 60% of the elderly live in developing countries, this proportion is projected to increase to 80% by 2050. The multi-pillar approach (first pillar: public pay-as-you-go system, second pillar: occupational private pensions, and third pillar: personal private pensions), although successful among middle to upper income formal sector workers, excludes many informal sector workers in emerging markets from the social security system. In this sense, the basic pension systems in developing countries typically cover less than 35% of the labor force, with less than 10% of workers in South Asia and Sub-Saharan Africa having pension coverage.
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Micro pension schemes are intended to collect savings at an early age and invest the funds collected at a reasonable return in order to accumulate capital which will serve as a regular stream of income throughout the life after retirement. In this way, a micro pension scheme facilitates domestic saving among informal workers, micro-entrepreneurs, small-business owners, non-salaried and low-income workers and helps reducing poverty among senior citizens by assuring them a source of income after retirement.
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Why is it micro?
Unlike traditional pension schemes, micro pension schemes are created to collect small, regular and sustainable savings by low-income people so as to provide them with a regular stream of income for the old age. It is worth mentioning that a traditional pension approach will hardly work for low-income people, because there are many key differences between traditional and micro pension schemes which have significant implications for design and distribution of micro pensions and associated costs. A micro pension scheme needs to address longevity, investment and inflation risks in the specific context of low-income people.
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Differences between micro pension and traditional pension schemes Traditional Pension Scheme
Micro Pension Scheme
Proximity
The pension fund manager is closer to customers.
Customers are usually far removed and less accessible.
Awareness
Awareness is higher among customers Convincing customers for renewals is a so convincing customers for renewal is routine part of the work and has to be rarely required done periodically
Preparedness to Customers are more prone to fulfilling fulfill contractual their contractual obligations (prompt payment of contributions due, etc.). obligations
Customers are not highly aware of the importance and consequences of nonfulfillment.
Post-affiliation work
Significant reduction in amount of work No significant reduction in amount of for agent in subsequent years. work for agent in subsequent years.
Number and value of transactions
Lower number of transactions but both Larger number of transactions though the total value and the unit transaction each transaction is of lower value. value are higher.
Periodicity of Transfers
Regular and periodic collections.
Weekly or monthly premium collections.
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Collection of Transfers
Easy collection of transfers through an electronic or other systematic means.
Transaction Costs Overall lower transaction costs. Transaction costs can be standardized
Administration Fees
Mainly door-to-door premium collections. E-payment is at infancy stage Overall higher transaction costs. Transaction costs are difficult to standardize.
Larger amounts mean that even smaller Such small premiums that even uncapped commissions can be sufficient because commissions can be insufficient due to of low volume of work. large volumes of unanticipated work.
Intervention of Intermediaries or third parties tend to intermediaries or be responsible for sales in the initial year. third parties
Intermediaries or third parties are mainly responsible for the entire customer relationship for several years after the initial sales.
Customer Contact Primarily via correspondence or phone Mainly in person. and sometimes in person.
Claims Handling Simplified by greater accessibility of customers, their education and their understanding of insurance.
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Complicated due to lesser accessibility and greater remoteness of customers, lesser education and lesser understanding of insurance.
Difference between micro pension and other micro finance products
While MFIs may have a very useful role to play in distributing micro pensions, there are inherent differences between the common micro finance products and micro pension schemes: Micro Finance Products
Micro Pension Scheme
Term
Short to medium term products (1-3 years).
Long term products.
Trust in the MFI
Important.
Critical. Trust must be backed by top class professional management over the long term.
Basis
Thrives mainly on group activity and peer pressure.
Individual based product.
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Different models
Different models might me adopted: o
Defined benefit (DB): The pension benefit is guaranteed based on the final or average salary of the worker
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Defined contribution (DC): The pension contribution (made by employer and/or employee) is fixed, but the benefit depends on investment returns
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Hybrid solutions: DB up to a basic level, DC on top of that basic level; Collective DC, participants share risks and returns collectively
Typically, a micro pension scheme is designed as a defined contribution plan providing for small value, frequent contributions which are collected at a place convenient to the member. However, when setting up the pension model, the following aspects must be taken into consideration: (i) cultural aspects,(ii) target group, (iii) government, (iv) macro-economic & financial environment, (v) institutional aspects, (vi) administration, (vii) asset management, and (viii) risks.
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To who is it addressed?
Micro pension products are mainly addressed at informal sector workers excluded from the multi-pillar pension system. It may also include micro-entrepreneurs, small-business owners, non-salaried and low-income workers. When it comes to micro pension schemes, the level of financial literacy of potential clients is rather low with regard to old age savings, estimating the lump sum required, functioning of mutual funds, facilities of modern financial markets, making investment decisions, understanding inflation and other financial planning knowledge. Thus, to create natural demand and ensure a good future for micro pensions, the staff of the MFIs must be able to explain basic ideas of financial planning, risk, yield and all above aspects to poor clients, in an easy and transparent manner. When selecting its customers, MFIs must pay special attention to: o
Financial situation of the customer: determine whether the customer has the ability to maintain her business / employment and whether he will be capable of making the periodical payments and fulfill its other obligations.
o
Ethical aspects of the customers: determine whether the potential customer has good work ethic and attitude, such as not kidding around or indulging bad habits like alcoholism and drug-taking.
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Further, MFIs should take into account that by helping clients learn how to minimize their own risks and build resilient to economic shocks (such as saving regularly to build up working capital) they would help strengthen the operations of the MFI in the long run. Finally, the following documents might be requested from the client when joining the micro pension scheme: (i) residence proof, (ii) photo, and (iii) determination of initial amount of savings.
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Who can provide the service?
Micro pension schemes are mainly developed, implemented and run by MFIs. However, NGOs and banks may also offer micro pension products to their clients. It is worth mentioning that while MFIs run the micro pension schemes and play a major role in the distribution of micro pension products, management of contributions should be left to a professional fund manager, who can invest and manage the funds prudently in order to obtain a reasonable return.
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How are micro pension products distributed among the addressees?
A variety of channels can be used to expand the coverage of micro pension schemes. The distribution channels must suit customers. They should deliver what clients want in a way that will reach them.
To provide cost-effective services to low-income people, the channels need to: o
Adopt an institutional and distribution structure that is suitable for today and can be adapted in the future (since micro pension products are long term products).
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Keep administrative costs low by using technology, outsourcing some functional responsibilities and leveraging existing infrastructure for distribution.
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Use a distribution system that is familiar and comfortable to the customers.
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Provide good service whereby the intermediary responds quickly and responsibly.
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Set up an effective collection system to minimize or prevent internal control lapses and also establish systems to ensure that controls and guidelines are properly followed in distribution.
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Do not mix distribution activities and avoid entangling pension contributions and credit risks.
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Clients need to be assured that their contributions will not be taken over.
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Clients need to be able to identify themselves (through id-card, passport etc.). This is an important factor for both distribution and administration. If there is no common mean of identification amongst the target population, one should be developed for this purpose.
The specific channels through which micro pensions can be spread depend on the characteristics and facilities of the country in which the micro pension scheme will be implemented. In India, for example, post offices have established presence in interior areas. Further, post offices enjoy a high degree of credibility among Indian population. Thus, post offices could be used to service low-income clients with regard to micro pensions. In such case, the personnel, although experienced in handling small savings, may need to be trained to service pension schemes. Moreover, the post office may need to offer flexibility in terms of deposit timings and even perhaps doorstep collection services to ensure regularity of savings. Other alternative channels could include producer organizations, agriculture and other unions, banks, insurance intermediaries, telecom companies, retailers and others. They are keen to enter the market and need to be incentivized to extend and distribute coverage of client responsive pension services to low-income people in a sustainable and scalable manner.
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How are funds collected?
Funds are usually collected in a weekly or monthly manner. However, the exact amount and periodicity of funds collection depends on each scheme and should take into account the specific characteristics of the customers to whom the micro pension scheme is addressed. When drafting the project for a micro pension scheme, the MFI should decide on the consequences of default in payment of the contributions due. Customers must be warned of the consequences of non-fulfillment.
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Who and how controls the integrity of the funds collected?
In the context of a micro pension scheme, MFIs deal with the savings of low-income people. Therefore, in order to avoid fraud and embezzlement MFIs are required the highest standards of governance, management and transparency. The focus must lie on enhancing the quality of governance, financial and accounting systems, MIS, record keeping internal audits, risk management and several other aspects.
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As a measure of caution, only those MFIs which have strong systems of voluntary savings would be entitled to distribute micro pensions, as in this case clients need to trust the institution more rather than vice versa. Further, management and investment of contributions should be left to a professional fund manager. Control of the MFIs shall take place both internally – through a supervisory board – and externally – through governmental control and / or an external auditor.
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Supervisory board: in charge of monitoring policy and executing management. Prior approval should be requested before adopting decisions addressing the following issues: amount of variable pay-out to pension scheme participants, age of retirement, adjustment mortality table, major adjustments in pension scheme characteristics, etc.
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External auditor: to perform an independent audit on the financial statements and policies of the MFI in order to confirm its proper functioning.
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Government control: micro pension schemes should be supervised by an independent regulatory authority. Further, government regulation and supervision is required to create a functioning and stable financial market in which the funds can be invested.
Administration fees
The larger number of transactions and high level of post sales service required year after year, involves higher costs of servicing clients. However, administration costs varies considerably even within a country context and depends on various factors such as (i) geography / remoteness, (ii) infrastructure availability / accessibility, (iii) premium collection frequency, (iv) mode of premium collection and amount, (v) availability of information on client level cash flow, (vi) extent of canvassing required for persistency, and (vii) renewals among others. Administration fees and costs could be reduced through auctions and other actions like proactively educating a large proportion of the population about the need for savings, old age security and pension. This must be backed by simpler products and schemes, competitive offerings, leveraging of technology and high quality of services / services delivery.
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How are the collected funds invested?
Funds collected shall be managed and invested by a professional fund manager. Ideally, the funds must have some sort of investment guidelines establishing how the contributions will be invested. Such guidelines should be flexible enough so as to adapt to the fluctuations of the market and of the specific fund. Contributions are usually invested in bonds and equities in order to obtain a reasonable return over them. It is worth noting that MFIs and NGOs must not regard the funds collected as sources of long-term capital for institutional use, because this puts elderly clients’ benefits at risk. Microfinance is a volatile business which can impact significantly in livelihoods of poor people. Thus, redeploying pension contributions for internal lending must be avoided at all costs. Otherwise, the hard earned money of the poor could be lost.
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When do people get their money back?
At a pre-agreed retirement age (usually between 55 and 65 depending on gender) the accumulated funds may be withdrawn either as a lump sum or annuity. The total amount accumulated depends on contributions made and investment returns, taking into account the administrative fees, investment management fees and other expenses. o
Lump sum: the accumulated funds are paid back in a single payment, which means that the retiree needs to calculate approximately how many years he/she is going to stay alive and plan his/her consumption in accordance with such estimation.
o
Annuity: is a fixed sum of money (based on life tables) that the person receives periodically, starting from the retirement date during the remaining period of life. It is the only way to deliver a pension during the whole period of life of the retiree. Therefore, it is the only financial instrument that can insure people from the longevity risk (the risk of living longer than expected without having sufficient funds to pay for living).
People should be able to choose at retirement age for a lump sum or annuity taking into account their specific needs. In this sense, if the person expects to live long after retirement he should opt for annuity, while people without a health insurance could use a lump sum in case they are seriously ill and need to go to hospital.
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Required saving amount to ensure a pension
When calculating the amount that should be contributed during active life in order to ensure a pension, several factors should be taken into account: o
Return on capital (interest rates)
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Whether the accumulated funds will be paid back as annuity or lump sum (in case of annuity, shocks in longevity - due to implementation of a new medicine, for example - can cause rapid growth in liabilities of the pension provider and default)
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Assumptions around survival (reliable information regarding life expectancy is required)
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Large impact of inflation on the required saving amount, among others.
Example: capital necessary for an annual pension of 7200 Annual pension: 7200 Average life expectancy after pension date: 15 years Return on capital: 9%
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Without inflation Saving 170 per year for 40 years can pay for a 15 years long pension of 7200
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With inflation Saving amount increases to 2700 per year, if the goal is to provide a pension
with the same purchasing power as currently 7200 do
Need for a sustainable system
In order to build up a sustainable system, savings coming in have to be balanced with the pensions going out. Two elements shall be taken into account: o
Growth of paying people by (i) young people joining the scheme, (ii) non-paying people becoming paying people (by increasing the retirement age), and (iii) people from outside the initial population joining the scheme.
o
Pensions paid for people that have never saved (except for some part of the initial capital). www.pensiondevelopment.org
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Risks involved
The micro pension scheme involves a number of risks. MFIs and professional fund managers have to adopt risk management mechanisms as a systematic and integrated procedure into the core business process of the organization. Risk management is as important as fund collection or investment.
The main risks involved are: Financial Risks
Operational Risks
Strategic Risks
Credit risks
Transactional risks
Governance Risks
Transaction
Human Resources
Ineffective oversight
Portfolio
Information Technology
Poor Governance
Liquidity Risks
Fraud / Integrity Risks
Reputation Risks
Market risks
Legal & Compliance Risks
External Business Risks
Interest rate
Foreign exchange
Investment portfolio
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Event Risks
Financial Risks: encompass risks that might arise from financial losses due to changes in market interest rates (interest risk), or due to inadequate protection from fluctuations in currencies (foreign exchange risk), or due to long term asset and liability management (investment portfolio risk). To mitigate these risks, a detailed study of the conditions of the markets shall be conducted and the pension scheme should be flexible enough so as to be able to adapt to market conditions. However, it is suggested to increase product flexibility only after the scheme has a suitable scale and is functioning smoothly. The reason for this is that increasing product flexibility at an early stage will increase the complexity and may be unfeasible from a cost standpoint.
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o
Operational risk: arises from the possibility of human or system related errors during the delivery of products or services. It is the potential that inadequate information systems, operational problems, insufficient human resources, inadequate staff skills, or breaches of integrity (fraud) will result in unexpected financial losses. Managing these risks require a combination of an effective internal control framework, appropriate information technology systems, employee integrity, transparent and prudent investment policies, and streamlined operating processes.
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Strategic risks: arise when a MFI has inadequate governance structure in place (governance risk) or if its market reputation suffers due to mismanaged operations or client interactions (reputation risk) or due to external market factors (external business risks and even risks). To minimize external risks or event risks, the MFIs must keep track of major macroeconomic, legal, regulatory and fiscal policy trends that have the potential to affect operations for each operating country. Actions should be taken as required.
In any case, an effective ‘feedback loop’ must be developed, even in scenarios where technology is used extensively, to update and maintain the data related to the scheme so that information can be reported effectively and timely back to decision makers so that they may act upon risks.
How to design a micro pension scheme? Example
All in all, when designing a micro pension scheme it is important to: (1) determine poor people’s demand for savings and insurance products already available; (2) pinpoint the weaknesses of these products; and, (3) if possible, include offsetting strengths into pension product design. MFIs must bear in mind that micro pension schemes have special characteristics, which make its design and distribution more difficult than in case of traditional pension products. In this sense, the key features of a micro pension scheme should include scalability, outreach, fair play and low cost, choice, sound regulation, sustainability and coverage. In addition, MFIs must take into consideration that micro pension schemes would necessarily differ from each other, since the characteristics of each pension scheme must depend on the specific necessities of the target group of people. An example of rules and regulations governing a micro pension scheme: o
Earliest starting age is 18 years and maturity age is 60 years;
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Deposits for a minimum of 10 years;
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o
Withdrawal before 10 years is allowed but the interest rate is decreased at 1% per time;
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Close of account is allowed after 10 years;
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At the time of opening the account, the client presents a nomination in the case of death;
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Interest rate regulation is as per RBI rules;
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Account can be single or joint (2 clients). At the time of closing, the information given at the time of beginning of the accounts will be considered; joint names are allowed to access the account;
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Necessary documents are: Residence proof, Photo and determination of initial amount of savings;
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If the deposit installments are not paid within 3 months, the penalty will be decided by the board of directors at that time.
Sources: 1. Uthira.D and Hansa Lysander Manohar, Economic Implications and Sustainability of Micropensions in the Era of Pension Reforms in India, International Research Journal of Finance and Economics, Issue 24, 2009. 2. Ramesh S Arunachalam, Micro-Pensions in India: Critical Issues, Challenges and Strategies for Future, Study for CORDAID, The Netherlands, unpublished article.
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