Investment Choice by Plan Members in OECD Countries with Selected Examples

1
Investment Choice by Plan Members in OECD
Countrieswith Selected Examples

• Development of Supplementary Retirement
  Provision in the EU
• and the Challenges to EU Accession Countries
• Sofia, 12-13 October 2006

2

• Origin(s) of member directed investment/portfolio
  choice in pension plans
• Prudential regulation of plan member investment
  choice
• Country examples
• Selected OECD and pension reform countries
• Policy issues

3
Origin(s) of member directed investment/portfolio
choice in pension plans

• Some kind of definition
• The life-cycle model
• Provides a model to explain saving/financial
  planning behaviour
• There are better and better results testing the
  model on real data and including more and more
  variables
• e.g. counting with investment decision variables
  changing with age
• Labour flexibility and wealth are important
  factors,
• but so as financial education and costs (of
  information, etc.)
• There are variables which are in correlation with
  age, but it does not necessarily means causality
• There are factors and groups that can not be
  captured by the model
• There is a slight difference in consumption
  smoothing and wealth maximalization, zero, short,
  or long term optimalization
• Pensions is only one source of savings in the
  model Social Security and guarantees affect the
  outcome
• Support side
• Liberalization and Development of financial
  markets and technology made possible new products
  since the 1980s
• Competition among financial institutions and fund
  operators
• Responsibility

4
Country examples

• The U.S.
• Canada
• Australia and Switzerland
• Examples of employer-based mandatory systems
• The regulation is more general in Australia, and
  so as the experience
• Sweden and Singapore
• Mandatory
• Centralized collection and fund and portfolio
  management, decentralized asset management
• Singapore CPF manages wide range of life-time
  financing issues (social security) in the same
  framework
• Chile
• Other pension reform countries Estonia and
  Hungary
• Plans to implement from 2005
• Denmark the Special Savings Pensions Scheme (SP)
  will offer choice from 2005
• Poland similar to Chile before 2002
• Slovakia similar to Estonia, plus scheduled
  withdraw of savings from risky funds as nearing
  retirement

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Country examples U.S.

• Employers responsibility
• Employees diversify out of employers assets
• Example TIAA-CREF
• Financial service provider to education,
  research, and healthcare professionals.
• About US290 billion in pension assets in trust
  for 3 million members
• Members my choose from 10 funds in five
  categories,
• Equity
• Fixed Income
• Money Market
• Guaranteed Funds
• Real Estate
• TIAA Traditional Guaranteed Funds,
• each fund including hundreds of securities
• Fund management fees range from approximately
  0.30 to 0.60 of assets.
• Extensive research and education activity
• Overall increase in equity excluding the extreme
  cases the distribution is quite smooth similar
  results from a life cycle model
• TIAA-CREF membership less labour uncertainty,
  and pensions from Social Security

6
Country examples - Canada

• Regulation
• Examples
• The University Of Western Ontario Pension Plan
• UWOPP allows members 15 investment options
• Diversified Equity or Bond or Long Term Bond
  Funds, Money Market Fund, Canadian Equity or Bond
  Funds, US Equity Hedged or Unhedged Funds,
  Non-North American Equity Fund, Balanced Growth
  or Income, Target Date Funds
• Target Date Funds invest in Government of Canada
  Bonds, assuming the investments are held to their
  target dates 2004, 2006, and 2008 , while
  offering liquidity of the investments before
  maturity.
• t a 59.20 p 420 a/p 67,735 c 0.08 r4
  2.91 r6 4.65 r8 5.76
• Another university example The McGill University
  Pension Plan
• A defined contribution plan with a defined
  minimum benefit, even if the account was not
  invested in the default fund
• Balanced Account Equity Pool Fixed Income Pool
  Money Market Pool
• A similar concept to the UWO Target Date Funds
  also implemented the Money Market Pool is
  intended to protect from fluctuations in the
  market
• The Balanced Account offers auto rebalancing,
  which might be better performed on fund rather
  than individual portfolio level
• --------------
• Different portfolios offer really different
  risk-return for different cost
• Matured systems low number of changes

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Country examples - Sweden

• The new mandatory pension system in Sweden
• NDC PAYGO (16 contribution rate), and DC
  financial accounts, or FDC (2.5 contribution
  rate)
• In the FDC system individuals can choose between
  one and five funds from over 500 funds 65
  equity funds,15 fixed-income funds, and 20
  mixed or life-cycle funds In addition There is a
  publicly managed mutual fund as the default fund.
• The Premium Pension Authority (PPM) administers
  the system
• Contributions are collected by the National Tax
  Authority. Information on payments is transferred
  on an individual basis to the National Social
  Insurance Board (NSIB). Money from new
  contributions is transferred through the National
  Debt Office to the participating funds, following
  the an order from the PPM. For 18 months
  Contributions kept on an interim account at the
  National Debt Office, earning a bond rate of
  return.
• The PPM is a clearinghouse for all fund
  transactions. Choices for new entrants and
  requests to buy and sell fund shares for all
  other participants are grouped together and
  executed jointly on each transaction day by the
  PPM. The PPM invests assets on behalf of
  participants, and is the sole client for any
  given fund. The PPM keeps the individual accounts
  of fund shares and values are computed for all
  trading days.
• The PPM is also the sole provider of annuity
  products.
• FDC Fund Participation Criteria UCITS, plus
  additional disclosure and daily information to
  the PPM. PPM also negotiate fees on a
  market-share basis.
• Fund Administration Costs 1.11 for equity
  funds, 0.70 for mixed and life-cycle funds, and
  0.60 for fixed-income funds, PPM charge up to
  0.3 , total administration costs 0.95
• FDC Fund Choices
• Initially 67 per cent of all participants made
  active choice The number of active fund choices
  was a little over 10 million. Participants chose
  on average 3.4 funds.
• Over 72 of those making active choices chose
  equity funds, and about 25 chose life-cycle
  funds.
• Inflows of capital are slightly biased
  towards equity funds 72 of invested capital,
  although the share of equity funds in the system
  is 68. (see 1/n rule)

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Country examples Chile

• The objectives of introduction of the multiple
  portfolio system was based on the life-cycle
  model, to increase the expected value of future
  pensions, by investing more efficiently during
  the active life with respect to age and
  risk-return profile.
• From August 2002, the number of managed funds by
  APFs were increased to five The multifunds are
  defined by minimum and maximum investment limits
  on equities. APFs are not obliged to establish
  Type A Fund (40-80), but Funds B E (0) must
  be created by all APFs. The definition of default
  selection also follows logic of the life-cycle
  model.
• The earlier mechanism of minimum return guarantee
  has also been maintained
• The basic rule for fund selection of members is
  free choice. However, older workers and
  pensioners, defined similarly as in the case to
  default fund selection, may invest only in less
  risky funds. Otherwise member may direct
  contributions in two different funds, and
  transfer assets into another Fund.
• The experience of active fund selection (and
  redirection) in Chile seems to support the
  textbook case
• 42 of the contributors made active choice.
• Participation in Fund A and Fund E (the two Funds
  that can be selected voluntarily) are
  significantly different in average age and
  accumulated funds, but not in average earnings.
  The difference might be explained by length of
  accumulation. This might support that young, high
  earning participants tend to choose the high risk
  fund, while retirees the low risk fund.
• Women tend to be more risk-averse while it seems
  to decrease by age.
• Redirection of contributions show correlation
  with returns. The number of changes to Type A
  funds have always been the highest. Since March
  2003 the gap in performance between Type A funds
  and Type E funds has increased, and the changes
  have followed the pattern.
• The above results show that plan members seem to
  make well informed decisions. Further analysis
  would be needed to compare the number of changes
  between funds, plans/fund managers (APFs) before
  and after the introduction of the multifondos.

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Country examples other pension reform
countries Estonia

• In Estonia pension fund asset managers may
  establish three type of funds
• Conservative 100 in fixed income (6 funds)
• Balanced 75 in fixed income and up to 25 in
  equity (3 funds)
• Progressive 50 in fixed income and up to 50
  in equity (6 funds)
• Three fund operators offer 2 funds (conservative
  and balanced), and the other three offer all
  three options. Two operators offer balanced funds
  for voluntary contributions, one balanced with
  the same limits and another all three strategy
  funds (with 100, 70, and 40 fixed income). The
  default option is the Conservative fund. In the
  mandatory system non-choosers were allocated to
  pension fund operators by drawing lots.
• Ministry of Finance established a statutory limit
  on the fees Unit issue fee max. 3, Unit
  redemption fee - max. 1, Management fee - max.
  2.
• The actual management fees range between
  0.75-2.0, according to fund type. Issue fee
  Between 1-3, according to fund operator
  redemption fee is 1 everywhere
• Majority of the investors chose the maximum
  equity fund, though in other circumstances it
  would have also been titled as balanced. It is
  also true, that plan members are young, because
  of the provisions of the law. Figures show that
  the proportion of members than assets is slightly
  lower in conservative and balanced funds than in
  Progressive. At this stage it might be explained
  even by the difference in management fees.

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Country examples other pension reform
countries Hungary

• Voluntary
• The main emphasis of regulation was on coherence
  with the investment regulation (limits and SIP),
  expensing and disclosure. The rules of operating
  multiple portfolio system in the pension plan
  must be approved by the General Assembly and
  licensed by the HFSA.
• All portfolios should adhere to the global
  limitations of the investment regulation, which
  allows maximum 60 shares and 30 foreign
  investment. The used benchmarks are short and
  long term, and composite Hungarian Government
  Bond indexes, BUX and MSCI World equity indexes,
  with respect to the asset composition of the
  portfolio
• Out of 82 voluntary pension plans 5 have multiple
  portfolios, covering 17 of total membership. Two
  plans have insurer as background organisation,
  two other are multi-employer plans and one is an
  open fund of a bank.
• The participating plans offer five (1), four (2)
  or three (2) portfolios. All funds have a default
  portfolio, which is not always the least risky.
  One plan applies a default/technical/temporary
  fund of 100 Hungarian Government bonds,
  similarly as in the Swedish system.
• The initial portfolio selection and switching
  from a terminating portfolio is free of charges.
  Two funds charge fixed amount (8, 10), with
  explicit reference to the actual real costs.
  Another one uses this condition, with 0.2 of
  assets plus 2, but maximum 40, but refundable
  on actual calculations by the end of the year.
  One fund charges simply 0.1 of assets.
• The plans disclose basic information about the
  portfolios on the internet, three revealing rules
  and fees, and two publishing also performance
  data, additionally to the required disclosure. In
  one plan the members are asked about their
  portfolio preference annually. In this plan the
  rate of answers with active selection is around
  15, and increasing, although about 50 of the
  choices select the suggested/default portfolio.
  Another fund offers a risk-tolerance assessment
  questionnaire.

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Country examples pension reform countries

• Active choice is high in a new, immature system
• Familiarity (known, domestic providers),
  education, costs, marital status, gender all
  influenced initial decision

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Policy issues

• Applicability of the life-cycle model is it
  demand or supply are we rational?
• Complexity, familiarity, financial education
• Applicability of portfolio selection
• In Voluntary systems
• Events that trigger change of portfolio
• Occupational pensions part of compensation
  scheme, members may expect the assets to be
  invested by professionals and it is not
  necessarily a problem
• In Mandatory systems
• DC mandatory
• Effect of guarantees
• Funds really differ in returns and fees
• The adequacy of information and professional
  advise that is provided
• System/Plan design issues adequacy to the
  participants/members default options
• Regulation technically ?

13
Prudential regulation of plan member investment
choice

• The U.S. ERISA Section 404(c) (1992)
• Canada Guidelines for Capital Accumulation
  Plans, Joint Forum of Financial Market
  Regulators (2004)
• Australia APRA regulation on Managing
  Investments and Investment Choice (1999)
• Hungary Amendments to investment regulation
  (2001)
• OECD Guidelines for the Protection of Rights of
  Members and Beneficiaries in Occupational Pension
  Plans (2003)

• Prudential governance and management is the same
  as in the case of a stand-alone fund
• But there are additional tasks because of
  multiplicity
• Definition of complementing portfolios with
  different strategies
• Maintaining a default fund
• Support plan members decision making
• Information provision
• Changing and termination of a portfolio, internal
  transfers
• Complex administration, IT
• Costs

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• The tendency in the last several years has been
  to offer participants in self-directed retirement
  plans more and more investment options.
  Economists generally believe that people are made
  better off when offered more choices, as long as
  they can always choose what they had before. But
  when people do not have the knowledge to make
  choices that are in their own best interests,
  increasing the number of choices does not
  necessarily make them better off. In fact, it may
  make them more vulnerable to exploitation by
  opportunistic salespeople or by well-intentioned
  but unqualified professionals.
• For better or for worse, these developments mean
  that people are being given more individual
  choice over their own asset accumulation and
  drawdown processes. .. From a social-welfare
  perspective, this development might actually be a
  step backward. Risk is being transferred to those
  who are least qualified to manage it.
• Zvi Bodie

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Thank you for your attention!

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