1.0
Background
Pensions the
world over are social policy initiatives to plan for retirement; a certain end
state in the lives of every working person. The period following the end of an
active working life usually comes with income shortages even when it is
available, which could lead to a fall in living standards of retirees. As a
safeguard, social policy makes retirement planning a major agenda for many
governments, trade unions, employers and employees in the wake of optimizing
retirement welfare. Pensions have therefore evolved as a tool to secure the
future of citizens. In simple terms, the common understanding of pension is
that it is fixed sum of money paid to persons commencing from retirement from
service usually via a scheme or plan. Often pension plans require both the
employer and employee to contribute money to a fund during their employment in
order to receive benefits upon retirement. It is a tax deferred savings vehicle
that allows for the tax-free accumulation of a fund for later use as a
retirement income. Pension plans are therefore a form of "deferred
compensation".
A vast typology
has emerged in different countries to describe pensions. For instance, pensions
are referred to as “retirement plans”
in the United States, “superannuation
plans” in Australia and New Zealand and “pension
schemes” in the United Kingdom. In spite of the varying terms, three basic
designs (types) of pensions schemes are common globally including defined
benefit (DB) plans, defined contribution (DC) plans or both. DC plans by nature
specifies contributions as a predetermined fraction of salary without certainty
of benefits upon retirement unlike DB plans. The latter is a promise by a
sponsor bearing responsibility to pay a fixed life annuity; sometimes
inflation-adjusted and benefits are a function of both years of service and
wage history. Whereas member contributions are ring-fenced and individually
invested in a DC model, DB enables the pooling and group management of funds.
Investment risk is emergent at two levels; investment performance uncertainty
and the real value of income streams or lump sum generated at retirement.
Therefore, DB plans offer superior risk-sharing properties that are not
captured by DC models.
2.0
Who “Benefits” from Pensions
Pensions are
typically in the form of a guaranteed life annuity, thus insuring against the
risk of longevity. In normative terms, all members of a scheme are intended to
benefit from pensions. However, the general reality in many developing
economies makes the need for pensions a rhetoric and a mere transplant of a
foreign ideal, ignoring the under-currents of real welfare needs. For instance,
life expectancies in many developing economies are substantially low, and many
pension scheme members may not live to enjoy the benefits of pensions. According
to the UNDP Human Development Report 2013, the Sub-Saharan Africa life
expectancy average as at 2012 is 54. 9 years, 64.6 years in Ghana, 57.5 years
in Kenya and 52.1years in Cameroon. Noting that compulsory retirement age in
most developing economies is around 60 years upon which retirement benefits are
paid, pension schemes may be unnecessary.
Thus, pensions are unreachable and a mirage to many. The majority of
those who survive after retiring at 60 years are normally expected to demise
shortly. In that case, such people may have contributed for over two decades,
sometimes four depending on when a person is employed; yet enjoys meagre
pensions for usually less than a decade as reported in many developing
economies. In Ghana, future pensioners born in 2012 are expected to demise at
age 64; hence, receive pensions for a likely four years.
At the group
level where people can be classified by income, the insignificance of pension
schemes is further perpetuated in many liberalized developing economies. It is
widely observed that low and middle-income people have low life expectancies
compared with high-income people all things equal. Very often, high-income
people have access to resources to live a high standard of life and for that
matter longer. This includes access to systems and life enhancing information,
which low and middle-income people predominantly lack. Moreover, the nature of
pension schemes favours high-income contributors, as benefits are mostly directly
linked with the contribution rate. In other words, many low and middle-income
people can only afford to contribute little and consequently earn little
pensions upon retirement, which in most instances is devalued by high inflation.
This is the case in many developing economies. Moreover, the fact that pensions
are periodic payments unlike lump sums to be received commencing upon
retirement expands the risk that many low and middle-income people in
developing economies would not received pensions – I refer to this as the “Retirement Planning Puzzle”.
This pushes the receipt of pensions further into the uncertain future. Unlike
developed economies with high life expectancies making pensions important, low
life expectancy in developing economies render the need for pensions unjustified.
In this article,
I seek to present a theorem to begin a discourse about the irrelevance of
pensions in developing economies – herein referred to as the “Pension Irrelevance Theorem” – and to
propose a model to optimize pensions for the many low and middle-income pension
scheme members. This is entangled in the “Retirement
Planning Puzzle” phenomenon, defined as the difficulty in achieving the
objects of retirement planning – thus the difficult in realizing and actualize
pensions. Through a discussion of the popular “housing as retirement income”
concept, I present some mechanisms which when woven into retirement planning could
enable scheme members to reasonably benefit from their deferred pension equity
(benefits) while a life. This could be a way to inject some efficiency into retirement
planning; hence the need for pension schemes.
3.0
The Retirement Planning Puzzle
The assumptions
underlying this puzzle are discussed below:
- Legal working age is 18 years and above. This is widely accepted as adulthood age at which persons are regarded as sound, matured and independent to make basic life decisions.
- Retirement age is 60 years in the majority of developing economies.
Observations
- Given a legal employment age of 18 years and retirement age of 60 years, many pension contributors would contribute towards pensions for approximately 42 years (i.e. 60 -18).
- Given that the average Sub-Saharan life expectancy is 54.9 years, many if not all pension contributors would demise before formal retirement age of 60 years.
- Based on observation (2), many if not all pension contributors would not receive pensions for that matter. Survivors would receive meagre pensions for less than a decade (10 years); precisely about 5 years.
Questions
- Why should people contribute towards pensions if they will not live to enjoy it?
- Is it possible for pension contributors to benefit from their deferred pensions during their working years?
4.0
Longevity and the Concept of Homeownership as Retirement Income
The concept of
homeownership as retirement income is popular in many advanced economies
including the United States, United Kingdom and Europe. This is based on the
principle that home equity could be released via home equity loans and reverse
mortgages as a substitute or complement to retirement income. High life
expectancies averaging 70 and above in developed economies heightens the need
for adequate retirement planning and therefore pensions. Housing as an asset in
the mixed portfolio of retirement assets has proven to be a good portfolio
diversifier, an inflation hedge and a deliverer of strong cash flow to members.
However, the
essence of home equity as retirement income although cannot be understated, is
not plausible in developing economies. This is because of the fact that many
people in the low and middle-income brackets constituting over two-thirds of
population in any developing country may not live after retirement age to
release the equity that has accrued from their homes. It seems to me that there
is an implicit assumption of homeownership; but it is common knowledge that the
majority of low and middle-income people are renters rather than homeowners.
Thus, there is no home equity to release to either substitute or complement
other sources of retirement income. Further, their housing conditions are poor
and inadequate and they lack the resources to access market-based formal
housing finance facilities. Most often, there is lack of innovation in housing
and housing finance design resulting in the pricing-out of low and
middle-income people from the housing market. These conditions highlight the
inefficiency in most housing markets in developing economies.
Nonetheless, the
relevance of housing as an inflation hedge cannot be underestimated in
developing economies with high inflation rates; a quality that retirement
investments (i.e. mostly stocks and bonds) lack. Yet, the very people who need
to tap this benefit to optimize their pensions largely do not own homes in
their life time. Moreover, those who are able to enter into homeownership are
very unlikely to release home equity because of the high desire to leave a
bequest; a social value often enjoyed over the economic benefits of
homeownership. Even in advanced economies, this phenomenon is true, although
slight. Thus, the dual likelihood of
missing out on pensions and homeownership is very high, a phenomenon which
questions the essence of pension schemes in developing economies.
5.0
Reversing the Pensions Irrelevance Theorem through Pension Housing Financing
The
situation is however not hopeless, as the retirement planning activity could be
tailored to enable pension contributors benefit from their deferred pensions
while alive. In other words, rethinking
the “homeownership-retirement planning”
philosophy by transposing the “homeownership
as retirement income concept” into “retirement
planning for homeownership” is vital in achieving this ideal. Shelter is
one of the most important physiological needs of humans, which in this era
comes in the form of houses. As the most significant component of household
wealth and the most important form of savings, acting as a source of protection
for household wealth against inflation in the long run; housing and
homeownership are very important aspects of human values, which does not only
provide shelter but serves as a measure of social standing and prestige. Home ownership in any form is important, but
owner-occupation grants individuals and households more independence, freedom,
more choices, better investment opportunities and the ability to borrow against
future income. Therefore, homeownership is one of the first priorities for most
households in most developing economies, representing the largest single
investment, taking 50% - 70% of household income.
“Retirement
planning for homeownership” already happens in the market for pension loans and
pension-secured loans in Southern Africa (predominantly in South Africa) and
Singapore. Pension loans are direct loans from the fund secured in two ways:
(i) over the member’s accrued benefits (which for the purpose of distinction
could be referred to as Pension Equity Loans) and (ii) effectively as a
mortgage loan in favour of the fund over the property in question. They are
financed and administered internally (by the fund) or through a designated
administrator depending inter alia on the in-house capacity, size and
nature of the pension fund. The size of the loan is primarily determined by the
accrued pension benefits which varies with time, size of contributions and returns
earned from investments. Pension-secured loans enable contributors to secure
housing loans by collateralizing their accumulated benefits to a third party;
the pension fund (or administrator) in this case acts as a guarantor. The loan
amount is limited to one third of the pension benefit outstanding at retirement
age and should be repaid for a maximum period of 30 years within the normal
retirement date. Repayment is bond-like in structure; monthly interest-only
payments to the lender via direct salary (payroll) deductions during the term
of the loan and the principal deducted from accrued pension benefits at the
maturity of the loan.
Aside
utilizing member’s (borrower) accrued pension equity (benefits), the pension
loan model allows a member to effectively in principle borrow other people’s
benefits as a mortgage. In this case, a borrower’s accrued benefits is
conceptually considered as ‘capital’ (deposit towards mortgaging),
whiles the accrued benefits of other members is employed as the ‘mortgage
loan amount’ --- supplement to the tune of the house price. Whiles in the
first model, the accrued benefits of a pension member is collateralized, the
second model utilizes the house as the loan collateral. In effect, both models
enable the activation of otherwise deferred pension benefits as spendable
income towards the acquisition of a house. The Financial Services Board of
South Africa notes that pension-secured loans amounted to R5 billion (£331.450
million) as at December 2005 and R10 billion (£662.900 million) in 2008 by
Alexander Forbes. By 2009, pension-secured loan totalled R17 billion (£1.127
billion) (Sing, 2009); demonstrating significant growth in the industry. With average
sizes of R19, 000 (£1,260), ±30% and ±70% of all pension-secured loans are from
retirement funds and third-party loan providers respectively (ibid.). According
to the Centre for Affordable Housing Finance in Africa (CAHF) (2012), there are
about 850 000 outstanding pension-backed loans based on average loan size of about
R20, 000. Default rates are low, reported at 2 percent in 2009 (ibid.). Pension
loans and Pension-secured loans have proven to be a remedy to the Pension
Irrelevance Theorem in South Africa.
Although the
Pension Irrelevance Theorem may not apply in Singapore because of longevity,
pension loans and pension-secured loans that have effectively connected their
housing developing activities with housing financing has benefited low and
middle-income earners. The Central Provident Fund of Singapore is a good
example; about 81% of the Singaporean population own a Housing Development
Board (HDB) flats, and over 95% of the adult population are homeowners. These
systems have allowed for the collateralization of pension equity to better the
housing conditions of low and middle-income households.
6.0
Applications of the Pension Irrelevance Theorem in Ghana
The Pension
Irrelevance Theorem provides useful remedies for the Retirement Planning Puzzle
in Ghana. The Pensions landscape in Ghana has undergone several developments
since the colonial era. In 1946, the Government introduced a non-contributory
pension scheme, which was the first pension program of its kind in the country,
to cater for the retirement benefits of those who worked in the offices of the
Colonial Administration. Later, in the early 60’s the “CAP 30” and
Superannuation Schemes were introduced for certified teachers, university
lecturers, and all government workers. The vast majority of ordinary Ghanaian
workers could not benefit from these schemes. Therefore, the Social Security
Act (No. 279) was passed in 1965 to cover all private and public sector workers
who were not covered by the “CAP 30” schemes. The scheme was originally started
as a Provident Fund to provide lump sum benefits for old age, invalidity and
survivor’s benefits. Since its establishment, it is a fact that the Pensions
Irrelevance Theorem has been operational and pensions have been less useful to
pensioners.
The transition to a broad investment portfolio
required considerations that satisfied the needs of government on the one hand,
the need to satisfy some social needs of the contributors and the need to
generate commercial rates of return to balance the lower rates from the other
portfolios. Hence, the passing of the New National Pension Fund Act, 2008 (Act
766) to establish a contributory 3-tier pension scheme is essential in
providing workers with improved benefits and income security “before
and after their retirement”. Unlike the former define benefit scheme (solely
managed by SSNIT) which provided contributors with no window of choice in the
investment of their contributions, the privately-managed defined contribution second
Tier of the new three Tier scheme allows members better control over their
pension benefits and investments.
Pension reform in
Singapore has been quite successful in providing basic needs and social
security for citizens in the country. About 27% pensioners take the benefits of
their accounts to pay for housing. Section 103 (2) of the new National Pension
Act, 2008 (Act 766) provides a similar leverage and potential remedy to the
Pension Irrelevance Theorem. Perhaps, this is the most important provision in
the Act which enables members to optimize the benefits from their pension
equity while alive; their greatest and most certain asset now - many
contributors may not live to enjoy pensions. It provides that “a scheme
may allow a member to use that member’s benefit to secure a mortgage for the
acquisition of a primary residence”. In other words, under this new system,
contributors may have access to some funds for specifically for housing, prior
to retirement. It is this provision in the new legislation that provides the
catalyst that establishes the legal background, making now the optimal time to
consider proposals for pension housing financing in Ghana. This means that
workers can obtain their own houses before retirement by using their pension equity
benefits as collateral, as against the problematic traditional brick and mortar
collaterals, which is a major constraint and source of high risk for mortgage
lending in Ghana. Essentially, this should translate into decent housing for
low and middle-income people and households. For those, who may live after
retirement, homeownership provides an upside; that is, the concept of housing
as retirement income could now be actualized. It is widely reported based on
the Preferred Habitat Theory that the second Tier scheme could serve as a
long-term source of housing/mortgage finance in Ghana. A feature which could
solve the maturity gap problem of lending long with short term deposits as is
the case currently. This could mitigate liquidity risk and reduce mortgage
rates substantially; hence improving housing/mortgage affordability.
7.0
Conclusion
In summary, many pension
contributors in developing economies would not live to enjoy their pensions;
thus, negating the need for pension schemes. However, pension schemes could be
made more malleable to create opportunities for members to use their deferred
pension equity (benefits) to meet housing needs via pension equity loans,
pension loans and pension-secured loans during their active lifetime which
could subsequently serve as a substitute or complement to retirement income
through home equity loans and reverse mortgages. The Retirement Planning Puzzle
and the Pension Irrelevance Theorem could be reversed through the new concept
of “retirement planning for
homeownership” as proposed by this paper.
Kenneth
Appiah Donkor-Hyiaman
MPhil
Planning Growth and Regeneration
Department
of Land Economy
University
of Cambridge
