Poor people need access to a variety of real and financial assets to build wealth. While using both formal and informal mechanisms, they seek the same financial goals as the rich, such as capital appreciation, risk mitigation, capital preservation, and financial leverage (i.e., increasing expected rates of return by assuming more risk). In order to achieve these goals, they must diversify among various financial products. Poor people invest in a variety of real assets: microbusinesses, gold, land, and livestock. While values of these real assets constantly fluctuate, these variations can offset one another when held concurrently, thus producing more constant rates of return for investors. However, helping poor people to build wealth should go beyond investment in real assets and extend to increased access to key financial products. Needs-appropriate credit, savings, insurance, and pension are key drivers of financial health among poor people. Pensions, in particular, aid in growing capital.
A Huge Untapped Market for Micropensions Exists in the Developing World
As populations worldwide are aging, the number of people over the age of 60 is expected to more than double by 2025 from 1.6 billion to 3.8 billion. There will be more than seven times as many elderly people, per capita, in developing countries versus industrialized countries by 2025; this number is expected to increase beyond 2025. With improved health care, although desirable, longevity increases, thus indicating that, at a rate of 2.1% growth per year, the elderly population in developing countries should increase by about 70% by 2025.
Income gains that the elderly worldwide made between the mid 1970s and early 1990s will be reversed by these new demographic trends and changes in longevity. The elderly in middle and upper income brackets can manage a 20% reduction in income, whereas the weight of this burden is too cumbersome for poor people who experience a diminished ability to purchase food, medicine and other necessities. As poor people attempt to reconcile increased longevity with the resulting diminished income, their ability to provide for their futures is increasingly hindered. In addition, traditional family care systems for old age security continue to decline, as their ability to cope with encumbering medical and other expenses associated with old age becomes increasingly difficult. Access to financial products can provide self-employed poor individuals with lifelong financial security. Pensions, currently unavailable to the majority of poor people, could offer this hope.
Limitations of Existing Pension Schemes
Countries providing pension often use a pay-as-you-go defined benefit system, meaning that each age group of workers contributes toward the fund for their predecessors, with the understanding that each following age group will continue to do so. As the population ages, however, contributions grow and surpluses become deficits. With defined benefits, pensioners are guaranteed a specific monthly benefit when they reach retirement. Professional money managers usually make investment decisions for pension funds and the fund, rather than the pensioner, assumes the investment risk.
The future of public pension systems should be in fully funded, defined contribution plans, not pay-as-you-go defined benefit plans. A "fully funded" plan indicates that workers finance their future by paying taxes today. This way, unaffordable promises and the inherent debt associated with them are avoided as assets earn interest. Workers make a "defined contribution" by depositing a certain portion of their income. These pensions can induce large-scale wealth building.
Existing similarities between savings, insurance, credit, and pension products serve as appropriate indicators for future product development. When designing pension funds for poor people, it is important: (1) to determine poor people's demand for savings and insurance products already available; (2) to pinpoint the weaknesses of these products; and, (3) if possible, include offsetting strengths into pension product design.
Pension Reform in Developing Countries Must Reach the Informal Sector
The World Bank has achieved strong results in reforming pension systems in developing countries. Of particular note is a multi-pillar pension system, which caters to each country context. The first mandatory pillar redistributes income and coinsures with government regulation and mandatory tax contribution. The second mandatory pillar increases overall level of savings and coinsures while regulated by individuals and private employers. The third pillar, by contrast, is fully voluntary or semi-voluntary, is managed privately, and is government regulated. Such a multi-pillar approach redistributes wealth from the rich to poor people; encourages savings; and, by reforming certain pension systems that are perceived to have failed, stimulates interest in saving for old age.
One example of the World Bank's success occurred through their reengineering of the Chilean pension system in 1980. Traits of the restructured Chilean "AFP system" include contributions to individual accounts, private management of the funds, choice among different pension providers, different forms of retirement payout, and the dependence of aggregate payout on account value. The plan has enjoyed much success. In fact, the number of pensioners grew from 4,465 in December 1982 to 530,397 in September 2004. This growth drove the total coverage of mandatory pension systems for the civilian population from 53% in 1982 to 70% in 1997. In addition, the aggregate value of pension funds that the AFPs managed grew from US$300 million (0.9% of the GDP) in December 1981 to US$54.06 billion (approximately two-thirds of the Chilean GNP) in October 2004 - a compounded real annual growth rate of 29%. The AFP system's strong results, coupled with the similarities between Chile's traditional (pre-1981) pension system and those of other countries, have spurred similar reforms elsewhere. Several countries have since come on board. Specifically, nine additional Latin American countries (Peru, Colombia, Argentina, Uruguay, Mexico, Bolivia, El Salvador, Nicaragua, and the Dominican Republic) and five European countries (Croatia, Hungary, Kazakhstan, Latvia and Poland) have introduced elements of individual capitalization and private management into their own pension systems.
Despite strong results, more pension reform is necessary. The multi-pillar approach, notwithstanding its successes, focuses on systems that serve middle to upper income formal sector workers. The basic pension systems in these 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.
This low level of participation in government old age security plans can be explained by a failure of contribution mechanisms to meet the informal sector's needs; an intentional avoidance of government pension funds, on the part of poor people, because of rampant corruption and poor management; and the failure of rates of return generated by most public pension funds to keep pace with inflation.
When poor people can and do participate in government pension, they are not guaranteed a payout during old age. Therefore, the more unstable a country's economy, the more important it is for its citizens to have access to private lifelong financial security. Even private pension funds, however, are not resistant to corruption. For example, private pension funds in Zimbabwe are required to devote 45% of their assets to government bonds that return 25% annually. With a current inflation rate of 187%, this (April 2005) requirement is equivalent to the government seizing 45% of the value of the funds.
An expected demographic shift leading to an exponentially larger elderly population coupled with poor people's willingness and ability to save for old age indicates that it is time for the microfinance sector to build efficient and effective instruments to help the informal sector save for old age.
The Future of Micropension Products
It is unlikely that coverage rates of microentrepreneurs and the self-employed will increase until a larger part of the population in developing countries joins the formal sector. In the short-term, making progress in expanding the safety net for elderly poor people hinges upon the development and launch of savings and insurance products by the microfinance sector that can effectively and efficiently assist in long-term asset building.
Despite their ability to allocate assets and their demand for asset growth, poor people often do not take part in pension plans. A direct relationship exists between firm size and the likelihood of pension program participation, with smaller firms being less likely to contribute to pension funds. For example, in Peru, microenterprises are only 0.2% as likely as the average firm to contribute, whereas firms employing more than 100 people are 450% as likely. The self-employed poor and microentrepreneurs are, in effect, untapped markets.
In order to rectify this discrepancy, five main challenges must be addressed: (1) Pension funds must specifically cater to the hard-to-reach informal sector; (2) Microfinance institutions must overcome any weak information systems regarding collection functions and record keeping; (3) Microfinance institutions and non-governmental organizations must alter their perception of pension funds as sources of long-term capital for institutional use because this puts elderly client benefits at risk; (4) the skills necessary for asset management and investment functions, which differ from selling microfinance products and services, must be utilized; (5) staff must be able to explain ideas of financial planning, risk, and yield to poor clients to effectively market pension funds.
Hybrid products offer microfinance institutions unique ways to increase capacity for offering micropension funds. Hybrid schemes that have similarities to savings products will be more likely to attract clients lacking complete financial literacy in comparison to pure pension plans. Rather than focusing purely on capital growth, hybrid products can focus on capital accumulation and therefore, the resulting security analysis for asset management would be less rigorous than that of a pure pension product. As a result, hybrid products can offer a successful transition into the design and implementation of profitable micropension products. With the development of such products, the microfinance sector can reach a largely untapped market and successfully create safety nets for elderly poor people.
About the author
Ms. Christina Barrineau held the position of Chief Technical Advisor for the United Nations Capital Development Fund during the International Year of Microcredit
in 2005. Currently, Ms. Barrineau is employed for the Bill and Melinda Gates Foundation.
About the United Nations Capital Development Fund
The United Nations Capital Development Fund
(UNCDF) is a UN organization mandated by the UN General Assembly and its Executive Board to provide capital assistance first and foremost to the Least Developed Countries (LDCs). UNCDF invests in LDCs in order to support their efforts to reduce poverty and achieve the Millennium Development Goals, especially in its two main product lines - Micro finance and Local Development. UNCDF is part of the UNDP-group and hosts the UN Advisors Group on Inclusive Financial Sectors.