Pooled Investment Funds — A tool to unlock long term financing sources (II)

This is second piece in a series of articles on pooled investments. They aim at informing us how other countries are using these tools to effectively mobilize financial resources for investment in productive activities within the economy – we should see this as a possibility for us as well. And so, in my last week’s piece, I started by saying – imagine if you are employed and earn a regular income, but could not rely on soundly-run pension funds, imagine how fearful you might be as you grew older, not knowing where your income was going to come from? I further said you probably are one of those who save their money under the mattress as one of the ways to reduce this fear. I further said — wouldn’t it be far better to save your money into the fund that invested that money in industries, projects, enterprises and in various assets classes within the economy in the form of shares, bonds, etc producing steady accumulation of wealth, which ends up benefitting you and (indirectly) others whose benefits ends up to you again, instead of saving under the mattresses?

In that article, I covered the concept of pensions – being one of the forms of pooled investment funds. Today, I will delve into the concept of collective investment schemes, but before I go there – I will touch on some further aspects of pension funds, this follows comments I received from readers of my last week’s article. So, yes there are “unfunded schemes” and “funded schemes”. Unfunded pension schemes, which are also termed as ‘pay-as-you-go” are schemes where the money put aside each month by employees and employer pays the pensions of current pensioners. This means that there is not a pot of accumulated money to pay pensions, and if there is a shortfall, it is met by the Government from its treasury. Looking around the world we see that the majority of state-funded pensions so far have been pay-as-you-go schemes, but many countries are in the process of reforming their pensions provisions as unfunded schemes have begun to prove unsustainable with the increasing age of the population and its increasing nature of dependency on the state.

Then there are “funded schemes” – these are designed so that the employees, and employers, make regular payments to a pension fund, which will (hopefully) grow and provide future pension income. Many employers run such schemes for their staff, one of the benefits of this form of scheme is that it can be designed as a low-cost scheme so that even very small and medium sized companies with just a handful of employees can also contribute to it without having to establish their own internally managed/administered schemes. The increasing longevity and the sharp fall in return on pension fund assets particularly in these past few decades have caused pension deficits (pension deficit arises when the actual amount of assets expected to be in the pension pot at retirement is not sufficient to pay out of the pensions required) in a considerable number of companies providing a kind of funded pension called “defined benefits pensions” – for the purpose of this article, I wouldn’t prefer to elaborate further on the workings of such schemes.

The last concept my readers allured into is the one known as “defined contribution” – this type of pension is becoming increasingly prevalent because it offers lower risk of unexpected liability to employers. The defined contribution pension is a pension where the contributions (from employees and employers) are fixed, but the actual pension paid out is linked to the return on the assets of pension fund and the rate at which the final pension fund is annualized; at the retirement age, an annuity is generally purchased with the accumulated funds to provide the pension. Under this arrangement, as investment performance before retirement and annuity rates fluctuates with the economic and financial volatility, it is entirely possible for the pension to be less (or more) than expected. And therefore, there is no obligation for the employer to guarantee a level of pension under defined contribution. If the fund underperforms while the employee is still working and saving in the scheme, or administrative costs rise, there will simply be lower pension. In other words, the risk of poorly performing investments is transferred to the prospective pensioners.

As it were, my intent for writing on this topic of pooled investment is to engage us on a possibility that someday in the near future these issues may be reflected in our country’s financing and investment policy frameworks and therefore we can somehow strategize the operability as we pursue our socio-economic development and growth; so, I would rather focus on the investment side, not the administrative or operations side as I have just done above under the request of my readers. Going forward, I’d request my readers to appreciate this. I will now go into elaborating the concept of collective investments, read on:

The idea of collective investments (pooled funds) has been around since around 1800. Its concept is simple; money from a group of people is gathered together and put into a range of investments. For investors this reduces the risk of total loss for all contributions by enabling them to invest in a far wide range of investments than they could individually; for corporate enterprises and the government it is source of sizable funds available for investing in productive investments. Worldwide, collective investments are responsible for a vast amount of funds, according to the Investment Company Institute (www.ici.org), worldwide mutual (collective) funds were at an astonishing US$ 28 trillion administered by about 70,000 funds by the end of 2016. Like the case with pension assets, where out of US$ 40 trillion global size, about 65 per cent is held by the United States pensions; again, the United States’ share of the global mutual funds’ assets is about 55 per cent (i.e. US$ 15 trillion), this being about 80 percent of the US Gross Domestic Product. These US$ 15 trillion US mutual funds’ assets are administered by about 9,500 funds. In our case, ever since the Government championed the concept of mutual funds/unit trusts about 15 years when the Unit Trust of Tanzania (UTT) was established, there has not been another notable such institution, we hence have only UTT as fund manager managing about 5 funds/schemes worth about Tsh. 250 billion (US$ 110 million) –about 0.25 per cent of our GDP. I wish private sector (i.e. insurance companies, banks, securities brokers, etc) could be in this space.

Collective investment offers some significant advantages to the investor, I will mention some of the advantages:

  • First, a more diverse portfolio can be created. Investors with a relatively small sum to invest, say Tsh. 5,000,000 (five million) would find it difficult to obtain a broad spread of investments to invest into without incurring high transaction costs. If, however, 1,000 people come together and each put Tsh. 5 million into a fund, there would be Tsh. 5 billion available to invest in a wide range of securities. A large fund like this can buy in large quantities, say Tsh. 100 million at a time in different assets classes (shares, bonds, money market instruments, etc) and in different companies, thereby reducing dealing and administrative costs per Shilling invested.
  • Second, even very small investors can take part in the stock markets and other financial markets – hence putting into practice the policy of financial inclusion and economic empowerment among many in the society. It is possible to gain exposure to the equity, bonds or other markets by collective investing for small amount (e.g. Tsh. 10,000 per month).
  • Third, professional management removes the demanding tasks of researching, analyzing and selecting shares and other securities to invest on, then going into the market place to buy, the time-consuming process of collecting dividends (no wonder we have many cases for many years of unclaimed and uncollected dividends in many of our listed companies), etc, all these nuances can be dealt with by handing the whole process over to professional fund managers.
  • Finally, if our capital account was fully liberalized, such individual small investments from individual retail investors’ investments could be made into exotic and far-flung markets ranging from South American companies, to US hi-tech industry, to Chinese technology companies, etc without the risks and complexities of buying shares direct. Collective funds run by managers familiar with the relevant country or sector can be a good alternative to going it alone.

These advantages, considerable as they are, but they can often be outweighed by the disadvantages of pooled funds, which includes high fund management costs and possible underperformance compared with the market index. Also, collective investments many lose any rights that accompany direct investments in shares, bonds and other such asset classes e.g. money market instruments – Treasury bills, bank fixed/term deposits, etc; for investment in shares, this include the rights to attend in the company Annual General Meetings and voting for appointment of directors, dividends payments, appointment of auditors, etc. We will continue next week.

Pooled Investment Funds — A tool to unlock long term financing sources

If you are employed, earning a regular income, but could not rely on soundly-run pension funds, now imagine how fearful you might be as you grew older, not knowing where your income was going to come from? Probably saving under the mattress is one way to reduce the fear, but wouldn’t it be far better to save into the fund that invested that money in industries, projects, enterprises and in various assets classes within the economy and (possibly) outside in the form of shares, government bonds, corporate bonds, infrastructure bonds, etc producing a nice steady accumulation of wealth, which ends up benefiting you and (indirectly) others whose benefits ends up to you again?

Wouldn’t it be better to have the discipline of being a member of the investment scheme that every month deducts contributions from your income whether that income is in the form of a salary, or business profits, or interest income, or rent income — that you will barely notice — and places it at arm’s length from you, under the professional management of funds managers, and you were forbidden to touch it until you were ready to retire or when you need it — depends on the scheme? And even after retirement, you could only take a portion of it each year — imposing another discipline to avoid you over-optimistically spending, or investing in a get-rich-quick schemes or other type of undesired schemes. Clearly, pension managers, fund managers, trustees, investment advisers and consultants provide an important service. Now further imagine if you could have part of your salary contribution in a statutory/compulsory pension scheme and part of it in the supplementary pension scheme.

But, other than pension, there are other groups of organisations that allocates funds to the purchase of securities is the pooled or collective investment funds — these types of pooled investment funds go under various names — from mutual funds and unit trusts (the like of Unit Trust of Tanzania – UTT) to investment trusts and investment companies (like the National Investment Company Limited – NICOL) to sovereign wealth funds and others. These funds help investors (especially retail investors and the less sophisticated) to spread their savings across a range of securities under the professional management; they also help in mobilisation of funds within the economy and direct them into productive sectors of the economy whether in private enterprises, in development projects, etc. In the next few weeks I will provide more details for each of the collective/pooled investment vehicles that I have mention above, in today’s article I will focus on the pensions, read on:

While many countries, ours included, provide a basic compulsory/statutory pension, however, as opposed to our current situation, statutory pension schemes usually need a top up by means of supplementary pension to give a reasonable quality of life for retirees and those who are temporarily unemployed. There are many types of pension available, even in our current state of pension space, but in whatever form, usually the person wishing to have a pension in the future or a form of regular income (even after retirement) has to begin the process of putting money aside to fund it. This fund is then put into an organisation that invest it to provide for the pension when required. The total amount invested in these kind of schemes at the global level is huge. The CityUK (previously the International Financial Services London) estimates that global pension assets totalled closer to US$ 40 trillion at the end of 2016, from about US$ 31 trillion in 2010. The major contributor to this US$ 40 trillion of global pension assets is the United States, with 63 percent of the total global pension assets — is by far the largest; followed by the United Kingdom which has 9 percent; Japan, Netherlands, and Australia each contributing 3 percent of the global pension assets; these are followed by Switzerland and Denmark each contributing 2 percent while Brazil, France and Sweden contributes 1 per cent; with the rest of the world contributing the other 12 per cent.

Now consider this statistics for a while, as of 2016 the United States Gross Domestic Product (GDP) was US$ 18.5 trillion, while its pension assets was about US$ 25 trillion — meaning, US pension assets is 135 per cent of it GDP. In our case in Tanzania, as of 2016 our GDP was estimated at about Tsh. 109 trillion (US$ 45 billion) while our total pension assets was Tsh. 11 trillion (US$ 5 billion) — about 10 percent of the GDP. Other than this data/statistics, the other aspect to note is that the pensions system in the United States consist of the social security system, a federal social insurance program which pays old-age pensions, as well as various personal/private pension plans. Keen to this is the personal/private pensions — what is this? Personal or private pensions are usually not provided either by the government or private sector employers. These puts the onus of funding a pension solely on the recipient, who pays a regular amount, usually every month or a lumps to the pension provider who will invest on their behalf. These funds from private/personal pensions are usually run by financial organisations such as insurance companies, banks, mutual funds, or unit trusts.

In our current situation, this aspect of the pension sector (i.e. personal/private pensions), plus the need to reform the current contributions system/structure so as to pave way for the development of the supplementary pension schemes, as well as the need for separation of statutory public pensions’ administration functions from their investments functions are the three key areas that require improvements or reforms to motivate the necessary change and so we can increase the vibrancy of the pension space and unlock the private fund management with its embedded efficiencies, and also unlock some idle funds which could be intermediated for the long term financing needs of our economy.

Going back to the state of major economies pension and the status of their investments: In the United States 58 percent of their pension funds assets are allocated in equities, 35 percent in bonds and 7 percent in other assets classes (i.e. real estate/property, bank deposits/cash, hedge funds, etc); in the UK — 54 percent is in equities, 36 percent in bonds and 10 per cent in other assets; in Japan 36 percent in equities, 47 percent in bonds while 17 percent of their pension assets are allocated in other assets; similarly in Australia it is 42 percent, 19 percent and 39 percent for equities, bonds and other assets respectively; so is the Netherlands where 28 percent of the pension assets are in the form of equities, 47 percent in bonds, and 25 percent in other assets. What does this mean? It means that pension funds are major investors in listed securities in their markets; it also means that these economies use pooled investment funds in the form of pension funds to invest in financial instruments issued by corporate enterprises, central governments, government agents, local government, etc — in this way they facilitate the mobilization of funds for investment in long-term enterprises and development projects within their economies; it further means that pooled investment funds in the form of pension funds are used as essential tools for the enhancement of the growth of their stock markets — as data above indicates in all these major economies over 75 percent of their assets are in the form of equities and bonds. In our case, this isn’t the case yet, we are at a situation where less than 10 percent of pension assets are in the form of listed equities and less than 20 percent of in the form of bonds.