Informal sector pensions: Sensibly investing for a better future

Successful implementation of long-term savings and pension accounts for the informal economy requires careful selection of investment instruments suitable for non-poor informal (NPI) household savings. Clearly, despite what may be spectacular recent investment performance, the current hottest venture capital fund would typically not be appropriate for such accounts, as such investments would be high-risk, volatile and hard to understand.

Instead, as explained in the recent World Bank report, “Social Protection for the Informal Economy: Operational Lessons for Developing Countries in Africa and Beyond,” the most suitable investments for such accounts would be the most liquid, high-quality and well-regulated assets available in each market.  Often this would include government debt instruments of various tenors and other high quality assets.

Overall, there are three key considerations that designers of NPI savings accounts should keep in mind as they define an investment policy. First, they should ensure that the scheme’s investments are a good match with the scheme’s design and objectives. Second, they should ensure that a positive net real return is achievable over the long-term given the scheme’s projected costs and portfolio components.  Finally, they should be careful to ensure strong governance.

Savings and pension accounts for the informal sector have varied designs and objectives. For example, many schemes include a short-term savings component along with the more typical long-term savings objective. Schemes that allow such short-term access to funds should have sufficient assets with near term maturities so that they can fulfill requests for withdrawals in the immediate future. Conversely, schemes with exclusively long-term objectives should predominately hold longer-term oriented assets.

The second consideration focuses on delivering a positive net real return over the long term. To do this, the scheme must not only invest in instruments oriented to the longer term but also be careful with regard to costs, so that the return delivered can ultimately be positive on a net basis. Keeping the investment policy simple while still diversified and minimizing any excess investment management costs is critical to delivering on this requirement.

A third aspect relevant to asset selection is the strength of governance. A scheme with strong governance, capable trustees with financial expertise, and minimal political interference can more safely diversify into additional asset classes. If trustees are less experienced, they may disproportionately favor areas of investment that they know, such as real estate, and avoid areas with which they are not as familiar, such as capital markets. The grid below shows the relationship between governance strength on the left axis and the capability of various assets to protect against the critical long-term risk of inflation. Schemes with strong governance have the ability to make use of more of these tools.

Ultimately, the challenge for these schemes is a balance of delivering acceptable returns while ensuring strong communication, engagement and understanding among participants. In designing investment guidelines for informal economy schemes, the policy maker faces the dual challenge of achieving a consistent long-term real return on the scheme investment (to make it attractive for informal economy workers) and communicating any drop in real returns to scheme participants who have low financial literacy. 

This has proved to be challenging for many would-be informal sector pension schemes, as both inflation and administrative costs can be major obstacles. But other schemes, such as some of the Tier III schemes in Ghana, have shown this is an achievable objective and those schemes continue to add participants. Coming up with a successful approach that is appealing to prospective NPI participants will be a crucial element in a wider social protection strategy to aid the informal sector globally.

This blog post is the fourth in a series focused on the different chapters of the report, "Social Protection for the Informal Economy: Operational Lessons for Developing Countries in Africa and Beyond."