Diversification without Diversification: Can the Multi-Pillar Pension Structure in Ghana Engender Diversification Risk in Pension Fund Management ? (Part I)

The road to pension liberalization was largely necessitated by unsustainable pension systems in Ghana. While the social insurance of family ties is weakening in recent times, the formal pension system prior to 2008 was like HIV/AIDS as described in some academic publications; meaning it was a slow-but-sure killer. The history of pensions in Ghana is marked by inadequate pension income, corruption and mismanagement. During this period, the pension system had just one pillar, which was a define benefit (DB) scheme. A DB scheme is a promise by a sponsor (in this case government) bearing responsibility to pay a fixed life annuity; sometimes inflation-adjusted and benefits are a function of both years of service and wage history.  Since DB schemes enables the pooling and group management of funds, it provides risk-sharing properties that are not captured by Defined Contribution (individual pension accounts) models. However, they were unfunded, in that funds were not set aside for the payment of pensions; rather, pensions were paid from tax revenue whenever due; thus, earning the name pay-as-you-go pension.

The growing number of pensioners and slow economic growth increased the cost of pensions to the government and practically made it unsustainable to maintain an unfunded one pillar DB pension system. It is within this pension sustainability debate that the almighty concept of liberalism, which has gain grounds since the 1980s due to what was referred to as the “the crisis of the welfare state” in the west and the “weakness of post-colonialist bureaucracies” infected global pension schemes. In simple terms, pension liberalism implies the privatization of pensions and retirement planning mainly through Defined contribution (DC) schemes. In this wake and championed by the World Bank in a report entitled “Averting the old Age Crisis”, a three-pillar pension scheme including a mixture of DB and DC schemes were proposed to salvage the looming global pension crisis.  Although the World Bank didn’t make a direct contribution as argued by Kpessa (2011), its ideology was lingering in the mind of the Bediako Committee that undertook the pension reform in Ghana. Hence, the reason for the current three-pillar pension system in Ghana.

In this article, which is Part I of these series, I wish to share with readers some insights into the inherent risk of the neoliberal new three-pillar pension system in Ghana, which we shall refer to as “diversification risk”. This risk potentially exist as a result of the separation of the management of first and second mandatory pension contributions. While the separation of the management function provides diversification benefits, it also engenders risk given the high level of financial illiteracy in Ghana. Therefore, to borrow the words of the English Poet John Keat (1819), the separation process embodies the “Contrarieties of Life: the Irreconcilable but Inseparable Opposites of Life” – where there is life, there is death. In this case, its advantages could be in itself a disadvantage from a portfolio management perspective. This implies that merely dividing the pension system into three tiers does not necessarily mean diversification although one of the goals of the new multi-pillar pension system in Ghana (Kpessa, 2013; 2011; World Bank, 1994). I will work through some simple estimations to demonstrate the phenomenon of diversification risk. The rest of the article will focus on describing the latent diversification risk in our new pension system and how it could manifest and be magnified by financial illiteracy and information asymmetry – unequal information among economic agents; i.e. pension fund managers and pension contributors who make investment decisions.

The Bediako Commission set up in 2004 led to the enactment of the current National Pension Act, 2004 (Act 766) to introduce a contributory three-tier pension scheme to provide improved retirement benefits for all workers. The ACT requires employers to contribute 13% and workers 5.5% of gross income, making a total contribution of 18.5%. This distribution is presented below:

a.     First tier basic national social security (defined benefit –DB) (13% out of total contributions); which is managed by the Social Security and National Investment Trust (SSNIT) is mandatory for all employees in both the private and public sectors. 2.5% out of 13% is a levy for the National Health Insurance scheme;

b.     Second tier mandatory occupational (or work-based) “defined contribution (DC)” pension scheme (5% out of total contribution) is “fully funded” by employees and privately-managed by approved Trustees assisted by Pension Fund Managers and Custodians. It is designed primarily to give contributors lump sum benefits.

c.     Third tier voluntary provident fund and personal pension schemes, supported by tax benefit incentives for workers in the informal (blue collar) and formal sectors (white collar).

The three tiers (pillars) of the new pension system constitute a portfolio of pension investments, which has investment diversification as one of its goals. Under section 176 – Permitted Investments, pension fund managers have nine classes of investments to choose from, which broadly cover a host of capital market and money market investments. These include shares (ordinary and preferential), bonds (government and corporate), Treasury bills, investment funds like mutual funds and unit trusts, debt securities and real estate, etc. Each of these investments have unique risk and return profiles (behaviours) and are likely to provide diversification benefits as investment portfolio management requires. The principle of diversification implies putting your eggs in different baskets, so that in the event of loss, some baskets of eggs (investments) may be saved. In other words, as one basket of investments is doing well, another may be doing badly, so that the performance of the latter is compensated for by the former. Therefore the average (mean) return is the expectation of the investor. Where all investments are put in one basket, the mean is the same as the total return on the one basket of investment, which may increase the risk of the investment portfolio  without commensurate return.

Diversification Risk and the Separation of the Pension Management Function

Diversification is thus effective when selected investments behave differently. In the one basket investment scenario above, all the investments behave the same and likely to provide little or no diversification potential. However, in the different investment basket scenario, diversification is likely to be maximized; i.e. returned maximized and risk reduced. Diversification is most effective when the pension fund manager has perfect information about the investment types he/she is investing in. In that case, he/she may not put all his eggs in one basket. A statistical measure of diversification is the correlation of returns, which measures the relationship between investment assets returns. The lower the correlation, the better the diversification potential; so zero and negative correlations may provide better diversification than positive correlations between assets. A zero correlation means that there is no relationship between the return behaviour of the portfolio of investments. A negative correlation means a negative relationship, so that when the returns on one asset (A) is moving up, the return  on asset (B) is falling and vice versa, which is preferred.  A position correlation indicates that returns are moving in the same direction, which is mostly not preferred. diversification therefore minimizes the volatility (risk) of asset returns whiles maximizing returns.

Although the new pension system is restructured and obviously divided (diversified) into three different baskets of investments, the benefits of diversification may be elusive as the separation of the management function comes with “information asymmetry” among pension fund managers. In this vein, the first tier DB social security scheme is managed by the SSNIT; the second tier DC will be managed by pension fund managers appointed by pension trustees on behalf of pension contributors; and the third tier by the NTHC as proposed. Since, the latter is voluntary, we will focus on the first and second mandatory schemes from here.

Private pension fund managers are experts in investing in particular financial instruments, say bonds or shares or real estate. Despite their expertise, the likelihood that they may lack information about SSNIT’s investments of the first tier DB funds cannot be compromise. Hence, the separation of the management function as a result of neoliberalism (privatization) potentially could create unequal information (asymmetry) between SSNIT and private pension fund managers of the second tier, which could have the effect of compromising the benefit of diversification as required by having different baskets of investments. In other words, although the structure of new pension system is diversified in theory, diversification in practice may be unachievable because the managers of the two different baskets of investments, SSNIT (first tier) and private pension fund managers (second tier) may invest in the same investments, say bonds or shares or real estate at the same time. In effect, they may end up putting all of contributors’ contributions in one investment basket. The failure of this one investment basket means that everything fails unlike a situation where investing in different assets may save some. For the purpose of understanding the concept of diversification risk, I will discuss two scenarios; (1) an undiversified portfolio and (2) a diversified portfolio.

For instance, if SSNIT and the private pension fund managers invested in the same real estate investment vehicle, which produced a return of zero (0%), then the SSNIT will receive zero (0%) and the private pension funds also zero (0%). The total and average returns are both zero (0%); [i.e. 0% + 0% = 0% and (0% + 0%/2) = 0/2 undefined]. This is the worst case scenario of an undiversified portfolio. However, if SSNIT invested in real estate and the private pension fund managers invested in bonds which yields zero (0%) and 5% respectively, then the average of the investments’ returns [i.e. (0% + 5%)/2 = 2.5%], which is 2.5% is what a contributor will earn. A contributor’s total return will be 5%, i.e. 0% + 5% in the diversification scenario. Thus, the low performance of real estate is offset by a positive high performance in bonds.  

Besides, the effect described above is not exactly as it will be, given that SSNIT’s investments are guaranteed by government; so irrespective of returns on their investment, government must provide a positive above zero return to contributors. Thus, government’s guarantee mitigates investment risk – the risk that the investment will fail. This is because pension pay-outs from the first tier DB scheme is not market determined but by a formula which incorporates the length of service and contribution rate (how much a contributor saved with the government). Hence, using the same undiversified scenario above, if real estate yields zero (0%), the private pension funds and for that matter contributors will receive 0% but the contributor will not receive 0% from government guaranteed SSNIT managed pension funds. This is because governments as mentioned above usually commit (guaranteed) to pay a minimum return to contributors on its borrowings from the SSNIT; say 2% above inflation.  In this case, the total return becomes 2%; [i.e. 0% + 2%] and the average return [i.e. (0% + 2%)/2] will be 1%, which is better than the first undiversified scenario without government guarantee above.

The picture is even better with diversified portfolios with government guarantee of 2% minimum return above inflation. To illustrate this with the first diversified scenario, if market returns of SSNITs investment in real estate is zero (0%) but the private pension fund managers earn 5% from investing in bonds, then the total return and average return will be 7% and 3.5% [ i.e. 2% + 5% = 7% and (2% + 5%/2%) = 3.5%] respectively. This example is particularly important because it demonstrates that the “unguaranteed” privately managed second tier pension scheme should be watched closely with both eyes since returns (real) could be practically zero and even negative because returns are determined by market forces, which are volatile and uncertain. The phenomenon of diversification without diversification (“diversification risk” trap) fuelled by information asymmetry may exist in all multi-pillar pension systems, even in the advanced economies.

In Part II of these series, I will look at how “financial illiteracy” among pension contributors and “their right to make investment choices in the second tier defined contribution scheme” could manifest and magnify the diversification risk potentially inherent in the new multi-pillar pension system in Ghana.  

Kenneth A. Donkor-Hyiaman

kwakuhyiaman@gmail.com