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The Future of Multi-Pillar Pension Systems

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The Future of Multi-Pillar Pension Systems Lans Bovenberg and Casper van Ewijk The Future of Multi-Pillar Pension Systems DP 09/2011-079 The future of multi-pillar pension systems Lans Bovenberg Tilburg University and Netspar Casper van Ewijk CPB Netherlands Bureau for Economic Policy Analysis, University of Amsterdam and Netspar September, 2011 This paper takes stock of the evolution in pension systems and the challenges that remain for the future. It derives a typology of pension systems and uses this to discuss the strengths and weaknesses of alternative systems. After describing how pension systems in the industrial world have been facing similar challenges, this paper argues that pension contracts in various countries have developed in similar directions. In observing that the way that pensions are organized still differs substantially between countries, the paper discusses that this international heterogeneity is likely to remain in the future. A unique answer to what is the optimal pension system apparently does not exist; several alternative solutions exist alongside each other, depending on the specific historical, political and institutional context of each country. 1 Introduction This paper takes stock of the evolution in the pension system and the challenges remaining for the future. It describes how pension systems in the industrial world have been facing similar challenges. As a result, pension contracts in various countries have developed in similar directions. At the same time, however, the way pensions are organized still differs substantially between countries. This international heterogeneity is likely to remain in the future. A unique answer to what is the optimal pension system does not exist; several alternative solutions exist alongside each other, depending on the specific historical, political and institutional context of each country. We therefore derive a typology of pension systems, discuss the strengths and weaknesses of alternative systems, and sketch some important challenges for the future. The rest of this paper is organized as follows. Section 2 describes trends in pension insurance and the key remaining issues and trade-offs based on the analysis in this book. This section concludes that the reform of pension systems in response to common trends is underway but by no means finished. In order to answer the normative question how alternative institutional designs should ideally develop in the future, Section 3 develops a typology of pension systems. Section 4 investigates how the various pension systems identified in this 2 The future of multi-pillar pension systems typology can enhance intergenerational risk sharing. It considers also how these alternative pension designs can better tailor life-cycle planning and intragenerational insurance to individual heterogeneity. 2 Challenges to pension systems: Functions, trade-offs and trends For each of the three main functions of pensions described in Designing the pension system: Conceptual framework (Bovenberg and van Ewijk, 2011) and briefly reiterated here, this section discusses the most important trade-offs in the institutional design of the functions. It then indicates how various trends affect these trade-offs and how institutions have responded to these trends. Finally, the remaining challenges for each of the functions are explored. Table 1 summarizes the trade-offs, trends, responses and challenges. This table may serve as a starting point for our discussion of the challenges of the pension system; we consider each of the functions in turn. 2.1 Life-cycle planning To take account of intragenerational heterogeneity, pension arrangements should be tailored to specific idiosyncratic circumstances and individual preferences. Heterogeneity typically calls for consumer sovereignty. Unfortunately, however, empirical evidence suggests that households typically lack the basic financial knowledge, computational ability and willpower to implement optimal life-cycle planning and the associated intertemporal financial decisions under uncertainty. Accordingly, various ‘internalities’ complicate efficient individual intertemporal decision making under uncertainty. Moreover, delegating these complicated decisions to others may give rise to serious agency and governance problems, especially because financially illiterate individuals are poorly equipped to discipline suppliers. Institutions for life-cycle planning The government can address myopia and other ‘internalities’ that give rise to poor individual decision-making in life-cycle financial planning by forcing agents to participate in public earnings-related pension schemes. Alternatively, the state can make private pension schemes mandatory for workers. It can also mandate workers to take out pension insurance while allowing individuals to select their own insurance pool. The drawback of compulsion is that it typically cannot account for heterogeneity between consumers, especially because governments are reluctant to use information on specific features of individuals in setting compulsory insurance levels. To accommodate intragenerational heterogeneity, pension schemes can be tailored to groups of workers with the same specific features (e.g. the same type of human capital). Personal pension plans provided by insurance companies and other financial institutions can accommodate individual idiosyncratic features. These retail products, however, are typically substantially more costly than standardized wholesale products, in part due to substantial marketing costs and adverse selection. Lans Bovenberg and Casper van Ewijk 3 Trade-off: choice versus individual failure A fundamental trade-off bedeviling life-cycle planning is that between tailoring to intragenerational heterogeneity (in terms of individual preferences and circumstances), on the one hand, and containing individual imperfections, on the other hand. To illustrate, high compulsary saving levels with mandatory pooling of longevity risk may prevent myopic behavior and fight inadequate longevity insurance (see Section 2.3 below). At the same time, however, it may force people with low preferences for old-age consumption or those facing temporary borrowing constraints to save too much and to take out too much longevity insurance. Trade-off: competition versus mandatory pooling More individual choice increases competitive pressure on pension providers to better accommodate preferences of consumers and to contain costs. However, the more the scope for individual choice is increased and the more the market for pensions becomes contestable, the more suppliers tend to spend on public relations and marketing costs. This raises transaction costs passed on to consumers. Hence, as an instrument to discipline pension providers, the effect of more individual choice raising competition on costs is ambiguous. Indeed, individuals that suffer from imperfect decision making raise difficult governance issues. Table 1 Trade-offs, trends, responses and challenges Function Trade-offs Trends Responses Remaining challenges Life-cycle • Tailoring to • Increasing • More choice • Design choice planning heterogeneity heterogeneity options architecture versus containing • More demanding • Guided choice • Integral financial personal failures consumers (defaults) services • Competition versus • Better ICT lower transaction costs Inter- • Risk sharing versus • Ageing and • More complete • Labor market for generational political risk and maturing of risk-sharing older workers risk sharing labor-market pension funds contracts • Design optimal risk - distortions • Increasing • Risk-bearing sharing scheme competition on pensions • Risk management by labor and • Increased and more the government commodity flexible retirement markets ages Intra- • Fighting selection • Increasing • Actuarially fair • Employability of generational versus heterogeneity in pension systems older low-skilled risk sharing accommodating skills and • Tighter disability workers heterogeneity longevity and unemployment • Optimal mix • Insurance versus • More elastic insurance between saving and moral hazard labor-market insurance behavior 4 The future of multi-pillar pension systems Trends: more heterogeneity, more demanding consumers and better ICT In the face of growing heterogeneity and more demanding consumers, the first trade-off shifts towards tailoring to individual circumstances. The financial crisis, however, has shown that many individuals are poorly equipped to make financial decisions, thereby increasing the awareness of individual foibles. This increased awareness has shifted the trade-off towards containing individual failures. More individual elements require pension agencies to gather more information about specific relevant features of participants – not only the individual’s work history and family status, but also health, financial portfolio, housing status (home-owner or renter), and preferences. Better ICT has improved the possibilities to collect more information about individuals. However, privacy considerations and fears about a ‘big brother’ type of pension agency may prevent the potential of ICT from being fully exploited. Moreover, financial intermediaries are often not allowed to use individual information in the context of market regulation aimed at preventing risk selection or at ensuring a level playing field with other suppliers that do not have access to this information. ICT , however, may allow other providers to more easily get access to this information if the individuals concerned assent to this. Furthermore,
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