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.